ExpertHard1 markMultiple Choice
CPA · Question 23 · Area 3: Technical Accounting and Reporting
On January 1, Lessee Corp enters into a 5-year lease for equipment. <br/>- PV of Lease Payments: $100,000<br/>- Fair Value of Equipment: $100,000<br/>- Economic Life: 7 years<br/>- No transfer of ownership or purchase option.<br/><br/>How should Lessee Corp classify this lease and what is the expense pattern?
On January 1, Lessee Corp enters into a 5-year lease for equipment. <br/>- PV of Lease Payments: $100,000<br/>- Fair Value of Equipment: $100,000<br/>- Economic Life: 7 years<br/>- No transfer of ownership or purchase option.<br/><br/>How should Lessee Corp classify this lease and what is the expense pattern?
Answer options:
A.
Finance Lease; Front-loaded expense pattern (Interest + Amortization).
B.
Operating Lease; Straight-line expense pattern.
C.
Finance Lease; Straight-line expense pattern.
D.
Operating Lease; Front-loaded expense pattern.
How to approach this question
1. Check 5 criteria for Finance Lease (Transfer, Option, Term > 75% life, PV > 90% FV, Specialized). PV ($100k) = FV ($100k), so 100% > 90%. It is a Finance Lease. 2. Finance Lease expense = Amortization (flat) + Interest (declining) = Front-loaded.
Full Answer
A.Finance Lease; Front-loaded expense pattern (Interest + Amortization).✓ Correct
A
Since the PV of payments equals the Fair Value, it meets the criterion for a Finance Lease. Finance leases recognize Amortization of the ROU Asset and Interest Expense on the Liability separately. This results in a higher total expense in earlier years (front-loaded) compared to an Operating Lease (single straight-line lease expense).
Common mistakes
Thinking it's Operating because there's no transfer of ownership; forgetting the PV vs FV test.
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