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Chapter 21: Q 6CA_c (page 1252)

(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: 鈥淎lthough I don鈥檛 know much about the copiers themselves, there is a way to avoid recording the lease liability.鈥� 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.

(c) What should Suffolk do?

Short Answer

Expert verified

Answer

Suffolk must assess the circumstances to avoid being misled by Buchanan.

Step by step solution

01

Step-by-Step Solution

Step 1: Meaning of Bargain-Purchase option (BPO)

A BPO offers the lessee the option to purchase the leased asset at a price that is much lower than the estimated fair value of the asset and appears relatively certain to exercise the option.

02

Explaining the situation in Suffolk

Suffolk must evaluate if the circumstance provides a reasonable difference of opinion where professional judgment might lead to either a correct or incorrect conclusion or whether Buchanan is attempting to mislead. Suffolk must choose between debating with Buchanan and simply accepting his stance. Suffolk should weigh the pros and drawbacks of both options. Before making a choice, Suffolk may undertake more investigation into copier technology.

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Most popular questions from this chapter

Question: (Balance Sheet and Income Statement Disclosure鈥擫essee) The following facts pertain to a noncancelable lease agreement between Alschuler Leasing Company and McKee Electronics, a lessee, for a computer system.

Inception date

October 1, 2017

Lease term

6 years

Economic life of leased equipment

6 years

Fair value of asset at October 1, 2017

\(300,383

Residual value at end of lease term

鈥�0鈥�

Lessor鈥檚 implicit rate

10%

Lessee鈥檚 incremental borrowing rate

10%

Annual lease payment due at the beginning of each year, beginning with October 1, 2017

\)62,700

The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs, which amount to \(5,500 per year and are to be paid each October 1, beginning October 1, 2017. (This \)5,500 is not included in the rental payment of \(62,700.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation method is used for all equipment.

The following amortization schedule has been prepared correctly for use by both the lessor and the lessee in accounting for this lease. The lease is to be accounted for properly as a capital lease by the lessee and as a direct-financing lease by the lessor.

Date

Annual lease payments/Receipt

Interest (10%)

On Unpaid liability/Receivable

Reduction of Lease Liability?

Receivable

Balance of Lease Liability/Receivable

10/01/17

\)300,383

10/01/17

\(62,700

\)62,700

237,683

10/01/18

\(62,700

\)23,768

38,932

198,751

10/01/19

\(62,700

19,875

42,825

155,926

10/01/20

\)62,700

15,593

47,107

108,819

10/01/21

\(62,700

10,882

51,818

57,001

10/01/22

\)62,700

5,699*

57,001

0

\(376,200

\)75,817

\(300,383

*Rounding error is \)1.

(b) Assuming the lessee鈥檚 accounting period ends on December 31, answer the following questions with respect to this lease agreement.

(1) What items and amounts will appear on the lessee鈥檚 income statement for the year ending December 31, 2017?

Jennifer Brent Corporation owns equipment that cost \(80,000 and has a useful life of 8 years with no salvage value. On January 1, 2017, Jennifer Brent leases the equipment to Donna Havaci Inc. for 1 year with one rental payment of \)15,000 on January 1. Prepare Jennifer Brent Corporation鈥檚 2017 journal entries.

(Lessee Computations and Entries, Capital Lease with Unguaranteed Residual Value) Assume the same data as in P21-10 with National Airlines having an incremental borrowing rate of 10%.

George Company manufactures a check-in kiosk with an estimated economic life of 12 years and leases it to National Airlines for a period of 10 years. The normal selling price of the equipment is \(278,072, and its unguaranteed residual value at the end of the lease term is estimated to be \)20,000. National will pay annual payments of \(40,000 at the beginning of each year and all maintenance, insurance, and taxes. George incurred costs of \)180,000 in manufacturing the equipment and $4,000 in negotiating and closing the lease. George has determined that the collectibility of the lease payments is reasonably predictable, that no additional costs will be incurred, and that the implicit interest rate is 10%.

Instructions

(a) Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial lease liability.

Lessor Computations and Entries, Sales-Type Lease with Guaranteed Residual Value) Amirante Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Chambers Medical Center for a period of 10 years. The normal selling price of the machine is \(411,324, and its guaranteed residual value at the end of the noncancelable lease term is estimated to be \)15,000. The hospital will pay rents of \(60,000 at the beginning of each year and all maintenance, insurance, and taxes. Amirante Inc. incurred costs of \)250,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Amirante Inc. has determined that the collectibility of the lease payments is reasonably predictable, that there will be no additional costs incurred, and that the implicit interest rate is 10%.

Instructions

(a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items.

  1. Lease receivable at inception of the lease.

Lessor Computations and Entries, Sales-Type Lease with Guaranteed Residual Value) Amirante Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Chambers Medical Center for a period of 10 years. The normal selling price of the machine is \(411,324, and its guaranteed residual value at the end of the noncancelable lease term is estimated to be \)15,000. The hospital will pay rents of \(60,000 at the beginning of each year and all maintenance, insurance, and taxes. Amirante Inc. incurred costs of \)250,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Amirante Inc. has determined that the collectibility of the lease payments is reasonably predictable, that there will be no additional costs incurred, and that the implicit interest rate is 10%.

Instructions

(b) Prepare a 10-year lease amortization schedule.
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