Which statement is incorrect about initial direct costs?
a. Initial direct costs incurred by the lessee in finance lease are added to the amount recognized as an asset and to the finance lease liability.
b. In a direct financing lease, initial direct costs are added to the net investment in the lease.
c. In a sales type lease, initial direct costs are expensed as component of cost of goods sold.
d. For operating leases, initial direct costs are deferred and allocated over the lease term.
The correct answer and explanation is :
The incorrect statement is:
c. In a sales-type lease, initial direct costs are expensed as a component of the cost of goods sold.
Explanation:
Sales-Type Lease:
A sales-type lease is a lease in which the lessor recognizes a sale of the leased asset along with a lease receivable. It is typically treated as a form of financing arrangement. In this case, initial direct costs (such as commissions, legal fees, and other costs directly attributable to securing the lease) are not expensed immediately as part of the cost of goods sold (COGS). Instead, they are capitalized and included as part of the net investment in the lease, similar to how costs would be capitalized in a direct financing lease. These costs are then amortized over the lease term, in line with the recognition of lease income, rather than being expensed upfront.
Thus, the correct treatment of initial direct costs for a sales-type lease is to capitalize them and amortize them over time, rather than expensing them as part of COGS. This is why statement c is incorrect.
Correct Treatment of Initial Direct Costs:
- Finance Lease (Lessee): In a finance lease, initial direct costs incurred by the lessee are added to the right-of-use asset and the finance lease liability. This means that the lessee capitalizes these costs, and they are not immediately expensed.
- Direct Financing Lease (Lessor): In a direct financing lease, the lessor recognizes the initial direct costs as part of the net investment in the lease, which is the sum of the lease receivable and unguaranteed residual value. These costs are not expensed upfront but amortized over the lease term.
- Operating Lease (Lessee or Lessor): For operating leases, initial direct costs are deferred and then amortized over the lease term. This ensures that the cost is spread out evenly over the period the lease is active.
In summary, option c is incorrect because initial direct costs in a sales-type lease are capitalized and amortized, not expensed immediately.