[bean counter]

Can someone help me out with this question? I thought it would be considered a capital lease (lease term of 5 years, useful life of 6 = 83%), so I used the PV & annuity factor of 6 years. It is saying I should have used 5 years. Did I just confuse this completely?

A company leases a machine from Leasing, Inc. on January 1, year 1. The lease terms include a $100,000 annual payment beginning January 1, year 1. The machine’s fair value is $500,000 and the residual value is estimated at $20,000. The company guarantees the residual value. The useful life of the machine is six years, and the lease term is five years. The implicit rate of interest is 6% and is known by the company. The following present value factors are provided:

Five Years Six Years
Present value of $1 at 6% 0.7473 0.7050
Present value of an annuity due at 6% 4.4651 5.2124
Present value of an ordinary annuity at 6% 4.2124 4.9173

What is the value of the machine in the company’s balance sheet at lease inception?

A.
$446,510

B.
$461,456

C.
$520,000

Incorrect D.
$535,340

BEC - 84 *
AUD - 73, 76 *
REG - 70, 72
FAR - 09/08/16

[Substantive Testing]

I am not 100% sure, it has been a while since I touched my FAR materials, so please verify what I am about to say.
You only recognize the value of the fixed asset at full life if it has a bargain purchase price or a direct transfer at the end of the lease. If it doesnt, then asset is not going to be truly yours at the end of the lease, and you can only recognize it up to the lease term.

[mjbey1s]

I am working on FAR right now and know how this question works. It is a capital lease because the useful life is at least 75% of the lease term. For a lease though, you use the “LESSOR” of the lease term or useful life.

So the first step is to take the $100,000 annual lease payment times the present value of annuity due (because the payment is made the first day of the lease) for 5 years, which is 4.4651

100,000 x 4.4651 = 446,510

Then take the residual value times the present value of $1 for 5 years.

20,000 x 0.7473 = 14,946

446,510 + 14,946 = 461,456

The answer is B, correct???

[FJR23]

Because the payment was at the beginning of the period, you would use 5 years.

Annuity due v. Ordinary annuity

[mjbey1s]

The fact that the payment is at the beginning of the year holds no bearing on whether you use 5 years or 6 years for this problem. It only determines if you use annuity due or ordinary annuity.

The payment is made at the beginning of the year so it is an annuity due.

You use 5 years and not 6 years because 5 years is the LESSOR of the two.

[Substantive Testing]

@mjbey1s, I believe that is not quite right, or maybe you just needed more clarification on your explanation. If I have a capital lease of 5 years when the asset life is 6 years, and I also have a bargain purchase option that I am planning to exercise, then I have to use the PV of 6 years and not the 5 years. Therefore, it is not always the lessor. The lessor only applies to % rates, or when there is not going to be a transfer after the lease is over.

[mjbey1s]

@Substantial Assurance,

You are correct. I forgot about the bargain purchase option. If that exists, then you have to use the economic life of the asset. So then what is your take on why 5 years was used in the answer above and not 6 years?

[Substantive Testing]

Because this is a normal lease without the option to transfer at the end of the lease. Therefore, you use the PV of the lease term (5 years) and not the PV useful life of the asset (6 years). In this question you were right though, because there is no bargain purchase option or transfer of title at the end of the lease, you take the lessor of those 2. Just be careful when you think or say its always the lessor of those 2.

[mjbey1s]

Thanks for the correction. This also helps me because I have this test in 12 days and now I will remember this conversation. Although I got the right answer, now I have a better understanding for other possible situations!

[Substantive Testing]

Yes, FAR is a test that you really have to understand all ins and outs. The reason why I say this is because when I did well on the first testlet, they pulled out questions directly from hell to my testlets 2 and 3 up to the point that it made me feel miserable. I felt like I had to apply multiple concepts and rules in order to answer one question. I can tell you that I do not mind taking any of the other tests multiple times, but taking FAR once in a lifetime is enough.

[mjbey1s]

So you passed it the first try?

[Substantive Testing]

Actually no, I should have specified that “passing it once in a lifetime is enough” I took it twice. First time I went with concepts memorized and landed a 74. I dug a hole and cried for a day, then I bought Ninja MCQ, and did it over and over focusing on understanding the concepts. And then went in for my second match, felt miserable during and after the test, but then on score release day, I realized that I knocked it out of the park. If this is your first time taking this test, I recommend you to know all journal entries. I wish someone had told me that when I first took it.

[mjbey1s]

I made a little notebook and wrote out every journal entry in the becker book for all of FAR and plan on using that to look over during review. Did all of the Becker software, have attempted almost 3000 MC in Ninja, and I am getting through the SIMS now. Hope that will do it for me. Still have 12 days left to review more too.

[Substantive Testing]

Nice, that is exactly how I did it too, but I also wrote the concepts of the mcqs I got wrong in that notebook and reviewed it day and night. FAR is full of bizarre things, did you know that a not for profit museum that gets their restricted art burned down, and later get proceeds from insurance will record those proceeds in financing activities in the statement of cash flows? bizarre isnt it? Well my book was full of these. Just to throw you some stats, in Ninja I had 2300 attempts, seen all questions, 76 hours studied, 20/74 sims done, average 73%, trending 80%, and final test score was 81. Wish you good luck.

[Author]

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