Ch. 13: Case 13-4 Application of SFAC No. 13
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.
The transfer of a lease from the lesser to the lessee automatically shifts all the benefits and risks into the ownership of the lessee, it therefore should be capitalized by the lessee, and the economic effect is like that of installment purchase in many aspects. In both cases the lessee or the buyer enjoys most of the ownership rights.
b. How should Lani account for this lease at its inception and determine the amount to be recorded?
Lani should debit this lease as an asset and should credit as a liability, the amount that is equal to the current or present value at the starting of the lease term considering the minimum lease payments, the payments representing the execution cost together with other profits shall not be inculcated in that. If the determined amount however exceeds the fair value of the leased asset at the inception of the lease, this amount is then recorded as an asset, and the liability would be the fair value of the machine.
c. What expenses related to this lease will Lani incur during the first year of the lease, and how will they be determined?
During the first year of lease Lani will incur interest expense that would be equal to the interest rate that was used for the capitalization of the lease at the time of inception, multiplied by the net carrying value of the obligation/ liability. Lani will also incur a depreciation expense, based on the expected useful life of the lease, applying the method that is consistent with the company’s depreciation policy for other assets.
d. How should Lani report the lease transaction on its December 31, 2006, balance sheet?
On Lani’s December 31, 2006, balance sheet, the leased assets and the associated accumulated depreciation should be classified as non current assets and be identified separately on the balance sheet or be marked in the foot notes.
The liabilities recorded under the lease transaction should also be properly classified into current and non current liabilities and should be identified separately in the end of the year balance sheet.
- What criteria must be met by the lease in order that Doherty Company classifies it as a capital lease?
One or more of the following criterion shall be met by Doherty Company in order to classify the lease as a capital lease.
- Complete transfer of the ownership rights at the end of the lease term.
- The Lease term is 75 percent or more of the expected useful life of the asset.
- Option of bargain purchase.
- The present value of the lease payments exceeds 90 percent of the fair market value of the leased asset.
- What criteria must be met by the lease meet in order that Lambert Company classify it as a sales-type or direct financing lease?
A sales type lease or direct financing lease must involve the profit/loss of the dealer or the manufacturer which is the difference between the fair value of the asset at inception and its carrying value plus the initial direct costs. The conditions for Lambert Company to classify the lease as a sales-type or direct financing lease are similar to those applicable to the Doherty Company, i.e.
- Complete transfer of the ownership rights at the end of the lease term.
- The Lease term is 75 percent or more of the expected useful life of the asset.
- Option of bargain purchase.
- The present value of the lease payments exceeds 90 percent of the fair market value of the leased asset.
- Contrast a sales-type lease with a direct financing lease.
For a sales type lease the carrying value of the leased asset is considered as expense and is charged to the cost of the asset, and for the amount of sale, the present value of min lease payments is taken into account. Whereas in case of a direct financing lease, sales or expense is not realized at any stage, the asset is not shown on the books rather unearned interest revenue is recorded derived from the difference of values between the undiscounted min lease payments and the cost/ carrying value of the asset.
Reference
Michael W. Maher, Clyde P. Stickney, Roman L. Weil. (2007).The difference between sales-type leases with a direct financing lease. Managerial Accounting: An Introduction to Concepts, Methods, and Uses.589
