JonnyKay

The Mader Corporation leases an asset for five years with lease payments of $10,000 per year. If Mader classifies the lease as a finance lease, which financial statements are affected at the end of the first year?

A) Income statement and balance sheet only.

B) Statement of cash flows, income statement, and balance sheet.

C) Income statement only.

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The classification of a lease as a finance lease creates an asset, a debt obligation, financing cash flows (amortization of the loan), and operating cash flows (interest expense).

JonnyKay

For a finance lease, the amount recorded initially by the lessee as a liability will:

A) be less than the total of the minimum lease payments.

B) equal the present value of the minimum lease payments at the beginning of the lease.

C) equal the total of the minimum lease payments.

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With a finance lease, both an asset and liability are reported on the lessee's balance sheet, with lease payments divided between interest and principal components. The future payments on principal and interest must be discounted to present value at the beginning of the lease

JonnyKay

Which of the following statements regarding finance and operating leases is least accurate?

A) For financial reporting of finance and operating leases, no entry is required on the lessee's balance sheet at the inception of the lease.

B) During the life of an operating lease, the rent expense equals the lease payment.

C) Asset turnover is higher for the lessee with an operating lease than a finance lease.

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If the lease is an operating lease there is no entry made on the balance sheet for the lessee. For finance leases, the leased asset and liability are recognized on the balance sheet by the amount equal to the present value of the minimum lease payments using as the discount rate the lower of the lessor's implicit rate or the lessee's incremental borrowing rate.

JonnyKay

Which of the following statements about leases is least accurate?

A) In the first years of a finance lease, the lessee's debt to equity ratio is greater than it would have been if the firm had used an operating lease.

B) In the first years of a finance lease, the lessee's current ratio is greater than it would have been had the firm used an operating lease.

C) All else equal, when a lease is capitalized the lessee's income will rise over the term of the lease.

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From the lessee's perspective, if a lease is considered to be a finance lease instead of an operating lease, then the lessee's current liabilities will be greater until the lease has expired. This will result in a lower current ratio (larger denominator).
In the early years, the capitalized lease expense (interest plus depreciation) is greater than in the later years because interest expense decreases over time. Less expenses = more income.
In the first years of a finance lease the lessee's debt to equity ratio will be greater than if the firm had used an operating lease because in the case of the finance lease, the numerator is comprised of (debt + lease), while the numerator in the case of the operating lease is (debt) only. In addition, the greater capitalized lease expense flows through to decrease shareholder's equity (the denominator).

JonnyKay

Which of the following statements regarding the effect of a finance lease on the lessee's statement of cash flows is least accurate?

A) The change in the finance lease liability on the balance sheet is a cash flow from financing.

B) The interest expense portion of the lease payments reduces cash flow from operations.

C) The rental expense serves to reduce the cash flow for financing because it is an investment expense.

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In finance leases, there is only interest expense and principal repayment. Rental expense is only charged when the lease is an operating lease.

JonnyKay

Which of the following statements regarding the effect of a finance lease on the lessee's statement of cash flows is least accurate?

A) The change in the finance lease liability on the balance sheet is a cash flow from financing.

B) The interest expense portion of the lease payments reduces cash flow from operations.

C) The rental expense serves to reduce the cash flow for financing because it is an investment expense.

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In finance leases, there is only interest expense and principal repayment. Rental expense is only charged when the lease is an operating lease.

JonnyKay

Which of the following statements about leasing is least accurate?

A) Firms that capitalize their leases will have lower current ratios and higher debt to equity ratios than firms that structure their leases as operating leases.

B) The interest rate implicit in a lease is the discount rate that the lessor used to determine the lease payments.

C) If the lessor is only financing the purchase of an asset, the lease is considered to be a direct financing lease and gross profits are recognized at the inception of the lease.

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With a direct financing lease, the lessor recognizes profit as interest revenue over the life of the lease. A sales-type lease allows the lessor to recognize profits at the lease inception.

JonnyKay

Which of the following statements regarding a direct financing lease is least accurate?

A) The principal portion of the lease payment is a cash inflow from investing on the lessor's cash flow statement.

B) The lessor recognizes no gross profit at the inception of the lease.

C) Interest revenue on the lessor's income statement equals the implicit interest rate times the lease payment.

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Interest revenues are calculated by multiplying the implicit interest rate by net receivables at the beginning of the period.

JonnyKay

If a lessee enters into a finance lease rather than an operating lease, it can expect to have a:

A) higher debt-to-equity ratio.

B) higher return on assets.

C) lower debt-to-equity ratio.

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Leasing the asset with an operating lease avoids recognition of the debt on the lessee’s balance sheet. Having fewer assets and liabilities on the balance sheet than would exist if the assets were purchased increases profitability ratios (e.g., return on assets) and decreases leverage ratios (e.g., debt-to-equity ratio). In the case of a finance lease, the assets are reported on the balance sheet and are depreciated.

JonnyKay

For a given lease payment and term, which of the following is least accurate regarding the effects of the classification of the lease as a finance lease as compared to an operating lease?

A) The lessee's asset turnover will be lower for a finance lease.

B) The lessee's current ratio will be higher for a finance lease.

C) The lessee's debt-to-equity ratio will be higher for a finance lease.

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The lessee's current ratio will be lower because the current portion of the finance lease increases current liabilities, hence reducing the current ratio.