QUESTIONS ANSWERS ON FINANCIAL REPORTING:FINANCE LEASE CRITERIA
Under US GAAP (ASC 842), a lease is classified as a finance lease if it meets any of five criteria at inception. Lessees measure the lease liability and right-of-use (ROU) asset at the present value of lease payments using the rate implicit in the lease or incremental borrowing rate.
Finance Lease Criteria (The "OWNS" / 5 Tests)
A lease is a finance lease if the non-cancelable term is over one year and any one of these conditions holds:
· Ownership Transfer: Title transfers to the lessee by the end of the lease term.
· Purchase Option: The lease contains a purchase option the lessee is reasonably certain to exercise.
· Lease Term: The lease term is 75% of the asset’s remaining economic useful life.
· Present Value (PV): The PV of lease payments equals or exceeds 90% of the asset's fair value.
· Specialized Asset: The asset has no alternative use to the lessor at the end of the term.
Minimum Lease Payments (MLP) Components
Under traditional US GAAP models applied in exams, lease payments included in the PV calculation comprise:
· Fixed rental payments over the lease term.
· Bargain purchase option / Guaranteed residual value.
· Excludes: Executory costs (insurance, maintenance, taxes) paid by the lessee
US CMA Part 1 – US GAAP Finance Lease MCQs (2026 Pattern)
1. Under US GAAP (ASC 842), a lessee classifies a lease as a finance lease if:
A. Any one of the five finance lease criteria is met
B. At least three criteria are met
C. Ownership transfers and lease term exceeds 75% only
D. Present value exceeds 80% only
Answer: ✅ AA
2. Which of the following is NOT one of the finance lease criteria under ASC 842?
A. Transfer of ownership
B. Bargain purchase option reasonably certain to be exercised
C. Lease term is a major part of the asset's remaining economic life
D. Lessee intends to insure the asset
Answer: ✅ DD
3. A lease transfers ownership of the asset to the lessee at the end of the lease term. The lease is classified as:
A. Operating lease
B. Finance lease
C. Short-term lease
D. Variable lease
Answer: ✅ BB
4. Which criterion replaces the old bright-line 75% rule under ASC 842?
A. Exactly 75% of economic life
B. Major part of economic life (judgment-based)
C. More than 60% of economic life
D. More than 90% of economic life
Answer: ✅ BB
5. Which statement about the present value criterion is correct?
A. PV must equal exactly 90% of fair value.
B. PV represents substantially all of the fair value.
C. PV must exceed book value.
D. PV equals historical cost.
Answer: ✅ B
6. A lease contains a purchase option that the lessee is reasonably certain to exercise. The lease is:
A. Operating lease
B. Finance lease
C. Short-term lease
D. Service contract
Answer: ✅ B
7. Which lease criterion focuses on the nature of the leased asset?
A. Lease term
B. Transfer of ownership
C. Specialized asset with no alternative use to the lessor
D. Fair value test
Answer: ✅ C
8. Under ASC 842, at lease commencement the lessee records:
A. Only lease expense
B. Lease liability only
C. Right-of-use asset and lease liability
D. Depreciation only
Answer: ✅ CC
9. The initial lease liability equals:
A. Fair value of the asset
B. Present value of future lease payments
C. Historical cost of the asset
D. Salvage value
Answer: ✅ BB
10. Which account is amortized in a finance lease?
A. Lease liability only
B. Right-of-use asset
C. Cash only
D. Lease receivable
Answer: ✅ B
11. Interest expense on a finance lease is calculated using:
A. Straight-line method
B. Effective interest method
C. Units-of-production method
D. Declining balance method
Answer: ✅ B
12. Which expense pattern occurs under a finance lease?
A. Constant total lease expense each year
B. Higher total expense in earlier years
C. Increasing expense every year
D. No interest expense
Answer: ✅ B
13. Which journal entry is made at lease commencement?
A. Debit Cash; Credit Lease Liability
B. Debit ROU Asset; Credit Lease Liability
C. Debit Expense; Credit Cash
D. Debit Equipment; Credit Revenue
Answer: ✅ B
14. Lease payments reduce:
A. Only interest expense
B. Only depreciation
C. Lease liability (principal) and interest
D. ROU asset directly
Answer: ✅ \ C
15. Depreciation of the ROU asset is generally recognized:
A. Over useful life if ownership transfers; otherwise over lease term
B. Only over lease term regardless of ownership
C. Only when cash is paid
D. Never
Answer: ✅ A
Case-Based MCQs
16.
ABC leases equipment for 8 years. The equipment has a remaining useful life of 10 years. Ownership does not transfer, but the lease term represents a major part of the asset's life.
The lease should be classified as:
A. Operating lease
B. Finance lease
C. Short-term lease
D. Executory contract
Answer: ✅ B
17.XYZ enters into a lease with annual payments having a present value equal to 95% of the asset's fair value.
Classification?
A. Operating lease
B. Finance lease
C. Service agreement
D. Rental contract
Answer: ✅ B
18.A lease involves highly customized manufacturing equipment that cannot be used by another customer at the end of the lease.
Classification?
A. Operating lease
B. Finance lease
C. Short-term lease
D. Variable lease
Answer: ✅ B
19.At the beginning of Year 1, a finance lease liability is $500,000 with a 10% interest rate. Interest expense for Year 1 is:
A. $40,000
B. $45,000
C. $50,000
D. $55,000
Answer: ✅ C
20.Which statement best distinguishes a finance lease from an operating lease for a lessee?
A. Finance leases recognize interest expense and amortization separately.
B. Operating leases recognize interest expense separately.
C. Finance leases do not recognize lease liabilities.
D. Operating leases do not recognize right-of-use assets.
Answer: ✅ A
US CMA Exam Tip
Remember the 5 Finance Lease Criteria (Mnemonic: "TOPPS"):
- T – Transfer of ownership
- O – Purchase Option (reasonably certain to exercise)
- P – Lease term is a Major Part of the asset's economic life
- P – Present Value of lease payments equals substantially all of the asset's fair value
- S – Specialized asset with no alternative use to the lessor
Finance Lease (US GAAP) Illustration-Based MCQs
MCQ 1
ABC Corp. leases equipment with the following details:
- Lease term: 6 years ,Economic life: 8 years
- Annual lease payment: $25,000 ,Present value (PV) of lease payments: $120,000
- Fair value of equipment: $125,000 ,Ownership does not transfer.
- No purchase option.
Should the lessee classify the lease as a finance lease?
A. No, because ownership does not transfer B. Yes, because lease term is 75% of economic life
C. Yes, because PV is 96% of fair valueD. Both B and C
Answer: D Explanation:Lease term = 6/8 = 75% and PV = 120,000/125,000 = 96%. Either criterion is sufficient under traditional US CMA exam illustrations.
MCQ 2
A company leases machinery.
- Lease term = 4 years Economic life = 10 years PV of lease payments = $92,000
- Fair value = $100,000
The lease is classified as:
A. Operating lease B. Finance lease because lease term exceeds 50%
C. Finance lease because PV equals 92% of FV D. Short-term lease
Answer: C
MCQ 3
A lease contains a bargain purchase option.
What is the proper classification?
A. Operating lease
B. Finance lease
C. Short-term lease
D. Depends on lease term
Answer: B
MCQ 4
XYZ leases equipment.
- Ownership transfers at end of lease.
- Lease term = 5 years.
- Economic life = 20 years.
Classification?
A. Operating leaseB. Finance leaseC. Depends on PV testD. Short-term lease
Answer: B
MCQ 5
A company leases an asset.
- Fair value = $200,000
- PV of lease payments = $175,000
PV as % of FV equals:
A. 80%
B. 85%
C. 87.5%
D. 90%
Answer: C
MCQ 6
Lease information:
- Lease term = 9 years Economic life = 10 years Ownership remains with lessor.
- No purchase option.
Classification?
A. Operating lease B. Finance lease because lease term is major part of economic life
C. Operating because title doesn't transfer D. Short-term lease
Answer: B
MCQ 7
A lessee signs a lease.
- Annual payment = $30,000 PV of lease payments = $140,000
What amount should initially be recorded as both the lease liability and right-of-use asset (ignoring initial direct costs)?
A. $30,000 B. $140,000
C. $170,000 D. Fair value
Answer: B
MCQ 8
Equipment fair value = $500,000. PV of lease payments = $470,000.
Which statement is correct?
A. Finance lease due to substantially all fair value criterion
B. Operating lease because ownership doesn't transfer
C. Operating lease because lease term is unknown
D. Cannot determine
Answer: A
MCQ 9
Which of the following alone can result in finance lease classification?
A. Transfer of ownership
B. Bargain purchase option
C. Lease term for major part of economic life
D. All of the above
Answer: D
MCQ 10
Which amount is depreciated under a finance lease?
A. Lease liabilityB. Right-of-use assetC. Lease paymentsD. Interest expense
Answer: B
Case-Based MCQ 1
LMN Corp. leases equipment.
- Fair value = $600,000 Lease term = 8 years
- Economic life = 10 years PV of lease payments = $560,000
- No ownership transfer No purchase option
Which statement is correct?
A. Operating lease because ownership remains with lessor
B. Finance lease because lease term and PV criteria are met
C. Finance lease only because PV exceeds 80%
D. Operating lease because title doesn't transfer
Answer: B
Reasoning
- Lease term = 8/10 = 80%
- PV = 560,000/600,000 = 93.3%
Both indicate a finance lease.
Case-Based MCQ 2
ABC signs a lease.
- Lease liability recorded = $350,000
- First year's interest expense = $24,500
- Cash payment = $60,000
Reduction in lease liability equals:
A. $24,500B. $35,500C. $60,000D. $84,500
Answer: B
Calculation
Lease payment − Interest = Principal reduction
= $60,000 − $24,500
= $35,500
Case-Based MCQ 3
A company leases equipment.
- Lease term = 5 years Economic life = 12 years PV = $430,000
- Fair value = $450,000
Classification?
A. Operating lease B. Finance lease because PV is substantially all of fair value
C. Operating because lease term is less than 75% D. Cannot determine
Answer: B
PV/FV = 430,000 ÷ 450,000 = 95.6%
Case-Based MCQ 4
Lease details:
- Fair value = $900,000
- Annual payment = $110,000
- PV of lease payments = $870,000
Initial journal entry by lessee:?
ANSWER
Dr Right-of-Use Asset 870,000
Cr Lease Liability 870,000
Case-Based MCQ 5
Which expense pattern occurs under a finance lease?
A. Only lease expense
B. Interest expense and amortization expense
C. Depreciation only
D. Rent expense only
ANSWER B
Comprehensive Numerical Illustration
Scenario: Company A leases a machine on Jan 1, 2026.
· Fair Value of Asset: $100,000
· Economic Useful Life: 5 years (Annual straight-line amortization: $100,000 / 5 = $20,000)
· Lease Term: 3 years (covers 60% — Wait, let's adjust terms to trigger a finance lease via PV test → let PV equal $92,000 which is >90% of fair value).
· Annual Lease Payment: $32,093 due at the end of each year for 3 years.
· Discount Rate (Implicit/Borrowing): 8%
1. Initial Recognition (Jan 1, 2026)Calculate Present Value of 3 payments of $32,093 at 8%: PV=$32,093*PVIFA 8%,3=$32,093 * 2.5771 = $82,705 THIS 82,705 IS CUMULATIVE PV AMT(DISCOUNTED VALUE) AT THE END OF 3RD YEAR {Assume PV matches>90% test
Journal Entry:
Dr. Right-of-Use (ROU) Asset: $82,705 B/S NON CURR ASSET
Cr. Lease Liability: $82,705 B/S NON CURRENT LIAB
1ST YEAR END 1/(1.08)^1= 0.9259
2ND YEAR END 1/(1.08)^2=1/1.1664=0.8573
3RD YEAR END 1/(1.08)^3=1/1.2597=0.7938
SUM OF THIS 3 YEARS 3$ = 2.577 0.9259+0.8573+0.7938=2.577
PRSENT VALUE OF DISCOUNTED AMOUNT, EVERY YEAR 1 $(ANNUITY) TOTAL 3$ FOR THREE YRS BUT THAT DISCOUNTED TO 2.5771
Extract Value From Present Value (PV) Table
A standard Present Value of $1 Table (Single Lump Sum) provides the discount factors for various combinations of time periods (\(n\)) and interest rates (\(r\)):
Periods (\(n\)) | 6% | 7% | 8% | 9% | 10% |
1 Year | 0.9434 | 0.9346 | 0.9259 | 0.9174 | 0.9091 |
2 Years | 0.8900 | 0.8734 | 0.8573 | 0.8417 | 0.8264 |
3 Years | 0.8396 | 0.8163 | 0.7938 | 0.7722 | 0.7513 |
Cumulative Present Value Table (8% Rate)
Year (\(n\)) | Present Value Factor (PVF) | Cumulative Present Value Factor (PVIFA) |
1 | 0.9259 | 0.9259 |
2 | 0.8573 | 1.7832 (0.9259 + 0.8573) |
3 | \(0.7938\) | 2.5771 (1.7832 + 0.7938) |
| | |
2. Amortization and Interest Schedule (End of Year 1 - Dec 31, 2026)
· Interest Expense: Beginning LEASE Liability ($82,705) × 8% = $6,616
· Principal Reduction: EMI Payment YEARLY($32,093) - Interest ($6,616) = $25,477
· Ending Liability:OP LEASE LIAB $82,705 – PAYT $25,477 = ENDING LEASE LIAB $57,228
· Year 1 Income Statement Impact:
o Amortization Expense (ROU Asset): $82,705 / 3 years = $27,568
o Interest Expense: $6,616
o (Total expense is front-loaded compared to operating leases).
· Journal Entry for Payment:
o Dr. Lease Liability: $25,477
o Dr. Interest Expense: $6,616
o Cr. Cash: $32,093
· Journal Entry for Amortization:
o Dr. Amortization Expense: $27,568
Cr. ROU Asset: $27,568
