21 Accounting for Leases CONCEPTS FOR ANALYSIS 21
CONCEPTS FOR ANALYSIS
CA21-1 WRITING (Lessee Accounting and Reporting) On January 1, 2017, Evans Company entered into a noncancelable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Evans by the end of the lease term. The term of the lease is 8 years. The minimum lease payment made by Evans on January 1, 2017, was one of eight equal annual payments. At the inception of the lease, the criteria established for classification as a capital lease by the lessee were met.
Instructions
(a) What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a capital lease.
(b) How should Evans account for this lease at its inception and determine the amount to be recorded?
(c) What expenses related to this lease will Evans incur during the first year of the lease, and how will they be determined?
(d) How should Evans report the lease transaction on its December 31, 2017, balance sheet?
CA21-2 (Lessor and Lessee Accounting and Disclosure) Sylvan Inc. entered into a noncancelable lease arrangement with Breton Leasing Corporation for a certain machine. Breton’s primary business is leasing; it is not a manufacturer or dealer. Sylvan will lease the machine for a period of 3 years, which is 50% of the machine’s economic life. Breton will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Sylvan does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.
Sylvan’s incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Sylvan has no way of knowing the implicit rate used by Breton. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement.
Sylvan has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Breton is reasonably certain that Sylvan will pay all lease payments. Because Sylvan has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Breton. Assume that no indirect costs are involved.
Instructions
(a) With respect to Sylvan (the lessee), answer the following.
(1) What type of lease has been entered into? Explain the reason for your answer.
(2) How should Sylvan compute the appropriate amount to be recorded for the lease or asset acquired?
(3) What accounts will be created or affected by this transaction, and how will the lease or asset and other costs related to the transaction be matched with earnings?
(4) What disclosures must Sylvan make regarding this leased asset?
(b) With respect to Breton (the lessor), answer the following.
(1) What type of leasing arrangement has been entered into? Explain the reason for your answer.
(2) How should this lease be recorded by Breton, and how are the appropriate amounts determined?
(3) How should Breton determine the appropriate amount of earnings to be recognized from each lease payment?
(4) What disclosures must Breton make regarding this lease?
(AICPA adapted)
CA21-3 (Lessee Capitalization Criteria) On January 1, Santiago Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Santiago at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, is 75% of the fair value of the equipment.
The following information is peculiar to each lease.
1. Lease L does not contain a bargain-purchase option. The lease term is equal to 80% of the estimated economic life of the equipment.
2. Lease M contains a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.
3. Lease N does not contain a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.
Instructions
(a) How should Santiago Company classify each of the three leases above, and why? Discuss the rationale for your answer.
(b) What amount, if any, should Santiago record as a liability at the inception of the lease for each of the three leases above?
(c) Assuming that the minimum lease payments are made on a straight-line basis, how should Santiago record each minimum lease payment for each of the three leases above?
(AICPA adapted)
CA21-4 (Comparison of Different Types of Accounting by Lessee and Lessor)
Part 1: Capital leases and operating leases are the two classifications of leases described in FASB pronouncements from the standpoint of the lessee.
Instructions
(a) Describe how a capital lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming the lease transfers ownership of the property to the lessee by the end of the lease.
(b) Describe how an operating lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming equal monthly payments are made by the lessee at the beginning of each month of the lease. Describe the change in accounting, if any, when rental payments are not made on a straight-line basis.
Do not discuss the criteria for distinguishing between capital leases and operating leases.
Part 2: Sales-type leases and direct-financing leases are two of the classifications of leases described in FASB pronouncements from the standpoint of the lessor.
Instructions
Compare and contrast a sales-type lease with a direct-financing lease as follows.
(a) Lease receivable.
(b) Recognition of interest revenue.
(c) Manufacturer’s or dealer’s profit.
Do not discuss the criteria for distinguishing between the leases described above and operating leases.
(AICPA adapted)
CA21-5 (Lessee Capitalization of Bargain-Purchase Option) Albertsen Corporation is considering proposals for either leasing or purchasing aircraft. The proposed lease agreement involves a twin-engine turboprop Viking that has a fair value of $1,000,000.
This plane would be leased for a period of 10 years beginning January 1, 2017. The lease agreement is cancelable only upon accidental destruction of the plane. An annual lease payment of $141,780 is due on January 1 of each year; the first payment is to be made on January 1, 2017. Maintenance operations are strictly scheduled by the lessor, and Albertsen Corporation will pay for these services as they are performed. Estimated annual maintenance costs are $6,900. The lessor will pay all insurance premiums and local property taxes, which amount to a combined total of $4,000 annually and are included in the annual lease payment of $141,780.
Upon expiration of the 10-year lease, Albertsen Corporation can purchase the Viking for $44,440. The estimated useful life of the plane is 15 years, and its salvage value in the used plane market is estimated to be $100,000 after 10 years. The salvage value probably will never be less than $75,000 if the engines are overhauled and maintained as prescribed by the manufacturer. If the purchase option is not exercised, possession of the plane will revert to the lessor, and there is no provision for renewing the lease agreement beyond its termination on December 31, 2026.
Albertsen Corporation can borrow $1,000,000 under a 10-year term loan agreement at an annual interest rate of 12%. The lessor’s implicit interest rate is not expressly stated in the lease agreement, but this rate appears to be approximately 8% based on 10 net rental payments of $137,780 per year and the initial fair value of $1,000,000 for the plane. On January 1, 2017, the present value of all net rental payments and the purchase option of $44,440 is $888,890 using the 12% interest rate. The present value of all net rental payments and the $44,440 purchase option on January 1, 2017, is $1,022,226 using the 8% interest rate implicit in the lease agreement. The financial vice president of Albertsen Corporation has established that this lease agreement is a capital lease as defined in GAAP.
Instructions
(a) What is the appropriate amount that Albertsen Corporation should recognize for the leased aircraft on its balance sheet after the lease is signed?
(b) Without prejudice to your answer in part (a), assume that the annual lease payment is $141,780 as stated in the question, that the appropriate capitalized amount for the leased aircraft is $1,000,000 on January 1, 2017, and that the interest rate is 9%. How will the lease be reported in the December 31, 2017, balance sheet and related income statement? (Ignore any income tax implications.)
(CMA adapted)
CA21-6 ETHICS (Lease Capitalization, Bargain-Purchase Option) Baden Corporation entered into a lease agreement for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease in all terms except there is a bargain-purchase option. After the 5-year lease term, the corporation can purchase each copier for $1,000, when the anticipated fair value is $2,500.
Jerry Suffolk, the financial vice president, thinks the financial statements must recognize the lease agreement as a capital lease because of the bargain-purchase option. The controller, Diane Buchanan, disagrees: “Although I don’t know much about the copiers themselves, there is a way to avoid recording the lease liability.” She argues that the corporation might claim that copier technology advances rapidly and that by the end of the lease term the machines will most likely not be worth the $1,000 bargain price.
Instructions
Answer the following questions.
(a) What ethical issue is at stake?
(b) Should the controller’s argument be accepted if she does not really know much about copier technology? Would it make a difference if the controller were knowledgeable about the pace of change in copier technology?
(c) What should Suffolk do?
*CA21-7 (Sale-Leaseback) On January 1, 2017, Perriman Company sold equipment for cash and leased it back. As seller-lessee, Perriman retained the right to substantially all of the remaining use of the equipment.
The term of the lease is 8 years. There is a gain on the sale portion of the transaction. The lease portion of the transaction is classified appropriately as a capital lease.
Instructions
(a) What is the theoretical basis for requiring lessees to capitalize certain long-term leases? Do not discuss the specific criteria for classifying a lease as a capital lease.
(b) (1) How should Perriman account for the sale portion of the sale-leaseback transaction at January 1, 2017?
(2) How should Perriman account for the leaseback portion of the sale-leaseback transaction at January 1, 2017?
(c) How should Perriman account for the gain on the sale portion of the sale-leaseback transaction during the first year of the lease? Why?
(AICPA adapted)
