Chapter 21 Circuit Village Isn't Aware The 14 Rate

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P21-15

1. Application of Criteria for Determination

of Lease Classification

Column A Criteria Met Remarks

1. Transfer of ownership

at end of lease No

Column B Criteria Met

1. Collectibility assured Yes

2. Journal entries:

Orr Company (Seller-lessee):

2010

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P21-15 (continued)

During Repair and Maintenance Expense 10,200

the Property Tax Expense 20,500

year Insurance Expense 18,000

Cash 48,700

Foible Company (purchaser-lessor):

2010

Jan. 1 Heavy Equipment Leased to Others 3,000,000

Cash 3,000,000

ANSWERS TO CASES

C21-1

1. Initial direct costs are costs incurred by the lessor to originate a lease that (1) result directly

from acquiring that lease and (2) would not have been incurred had that leasing

2. Accounting treatment of initial direct costs

a. For an operating lease, the initial direct costs are recorded as a prepaid asset (if

material in amount), and amortized as an operating expense over the term of the

3. An argument can be made both for and against including initial direct costs in cost of

goods sold.

C21-2

1. By treating the lease as a sales-type lease, Jordan’s current position would be enhanced

because part of the receivable from the lease would be current with a resulting increase

2. Alternative solutions:

a. Transfer ownership to lessee at end of lease

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C21-2 (continued)

Note: While these changes may allow Jordan to treat the leases as sales-type leases, they

C21-3 (AICPA adapted solution)

Part a.

1. A lessee accounts for a capital lease as an asset and an obligation at the inception of the

lease. Rental payments during the year are allocated between a reduction in the

2. No asset or obligation is recorded at the inception of the lease. Normally, rental on an

operating lease is expensed over the lease term as it becomes payable. If rental

Part b.

1. The gross investment in the lease is the same for both a sales-type lease and a direct-

financing lease. The gross investment in the lease is the minimum lease payments (net of

2. For both a sales-type lease and a direct-financing lease, the unearned interest income is

amortized to income over the lease term by use of the interest method to produce a

3. In a sales-type lease, the excess of the sales price over the carrying amount of the leased

equipment is considered manufacturer’s or dealer‘s profit and is included in income in the

C21-4 (AICPA adapted solution)

1. The economic effects of a long-term capital lease on the lessee are similar to that of an

equipment purchase using installment debt. Such a lease transfers substantially all of the

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C21-4 (continued)

2. A lessee should account for a capital lease at its inception as an asset and an obligation

at an amount equal to the present value at the beginning of the lease term of minimum

3. A lessee should allocate each minimum lease payment between a reduction of the

4. Von should classify the first lease as a capital lease because the lease term is more than 75

C21-5 (AICPA adapted solution)

1. The economic effect of a long-term capital lease on the lessee is similar to that of an

2. a. Metcalf should account for the sale portion of the sale-leaseback transaction at

January 1, 2010 by recording cash for the sale price, decreasing equipment at the

undepreciated cost (net carrying amount) of the equipment, and establishing a

3. The deferred gain should be amortized over the lease term or life of asset, whichever is

appropriate. During the first year of the lease, the amortization will be an amount

C21-6 (AICPA adapted solution)

1. A lease is classified as a capital lease when it transfers substantially all of the risks and

C21-6 (continued)

1. (continued)

Lease J is classified as a capital lease because the lease term is equal to 80 percent of the

2. For Lease J, Borman Company records as a liability at the inception of the lease an

amount equal to the present value at the beginning of the lease term of minimum lease

payments during the lease term, excluding that portion of the payments representing

3. For Lease J, Borman Company allocates each minimum lease payment between a

reduction of the liability and interest expense so as to produce a constant periodic rate of

C21-7

1. The computer is shown on the financial statements of both United and Superior. United will

include the computer on the balance sheet because substantial uncertainties exist as to

2. If the lessor uses an interest rate lower than the lessee, the present value of the lease

payments could be greater than 90% of the fair value of the leased asset to the lessor but

C21-8 (AICPA adapted solution)

1. a. The lease is a capital lease because the present value of the minimum lease

payments is 90% of the fair market value of the asset.

(1) Leased Equipment

(2) Capital Lease Obligation

2. a. The lease is a direct financing lease because the present value of the future minimum

lease payments receivable is ≥ 90% of the fair value of the asset and the collectibility

of the lease payment is reasonably assured (predictable) and no important

uncertainty as to Thomas’ costs exists. The lease is not a sales-type lease because

C21-9 (AICPA adapted solution)

1. When a lease transfers substantially all of the risks and benefits incident to the ownership of

2. Lani should account for this lease at its inception as an asset and an obligation at an

amount equal to the present value at the beginning of the lease term of minimum lease

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C21-9 (continued)

3. Lani will incur interest expense equal to the interest rate used to capitalize the lease at its

inception multiplied by the appropriate net carrying value of the liability.

4. The asset recorded under the capital lease and the accumulated depreciation should be

reported on Lani’s December 31, 2010 balance sheet classified as noncurrent and should

C21-10 (AICPA adapted solution)

1. a. Comparisons of an equipment’s fair value to the present value of the lease payments,

and of its useful life to the lease term, are used to determine whether the lease is

equivalent to an installment sale, and therefore is a capital lease.

2. Port should account for the sale portion of the sale-leaseback transaction at December

3. On the December 31, 2010 balance sheet, the equipment should be included as a fixed

asset, at the lease payments’ present value at December 31, 2009, less 2010 amortization.

C21-11

Note to Instructor: This case does not have a definitive answer. From a financial reporting

perspective, GAAP is identified and summarized. From an ethical perspective, various

issues are raised for discussion purposes. This case is based on a real example. Since

contingent rentals are not discussed in the chapter, students have to research GAAP. In

FASB Statement No. 29 (par. 11) (FASB Cod. # 840-10-25) increases or decreases in lease

payments that result from changes in an index, such as the CPI, are contingent rentals

and excluded from the minimum lease payments (and accrued as earned).

From an ethical perspective, the issue involves whether it is appropriate to structure a

transaction in order to produce a desired financial reporting outcome–in this case,

presumably, the absence of a liability. The primary stakeholders are the company’s

current and potential stockholders and creditors. If the balance sheet amounts are not

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ANSWERS TO RESEARCH SIMULATIONS

R21-1

Note to Instructor: Students are expected to cite references to GAAP in their research of

this issue. They might use the FARS electronic database, pronouncements listed on the

FASB web site, the FASB Original Pronouncements, the FASB Current text, or other primary

sources of GAAP to obtain these references. They may also use the FASB Accounting

Standards Codification which is cited in parentheses.

To: Controller, Cliborn Company

From: Gail Naugle, Accountant

I have researched the issue of the appropriate classification of the lease under GAAP.

According to FAS 13, par. 7, (FASB Cod. # 840-10-25-1) a lease is capitalized when any one

of four conditions is present:

a. The lease transfers ownership of the property to the lessee at the end of the life of the

lease.

The lease for the retail store clearly does not meet either criterion (a) or (b).

The application of criterion (d) raises problems because individual stores in multi-store retail

Therefore criterion (c) is the only one left to apply to this lease. Since real estate is

commonly depreciated over lives much greater than 30 years and the shopping center is

new, the 20 year life of the lease is less than 75% of any reasonable life assigned to the

property. Therefore, the lease is an operating lease.

R21-2

Note to Instructor: Students are expected to cite references to GAAP in their research of

this issue. They might use the FARS electronic database, pronouncements listed on the

FASB web site, the FASB Original Pronouncements, the FASB Current text, or other primary

sources of GAAP to obtain these references. They may also use the FASB Accounting

Standards Codification which is cited in parentheses.

To: Jim Stirbis, President

From: Shannon Fenimore, Accountant

I have researched the issue of the appropriate classification of the lease under GAAP.

According to FAS 13, par. 7, (FASB Cod. # 840-10-25-1) a lease is capitalized when any one

of four conditions is present:

a. The lease transfers ownership of the property to the lessee at the end of the life of the

lease.

Also according to the FAS 29, pars. 10 and 11, (FASB Cod. # 840-10-25) contingent rentals

are excluded from minimum lease payments. Lease payments that depend on a factor

directly related to the future use of the leased property, such as sales volume, are

excluded from minimum lease payments in their entirety.

It is also important to note that the four criteria measure whether substantially all the risks and

benefits of ownership have passed. However, there is no room to use judgment in applying this

broad principle. It seems to me that substantially all the risks and benefits of ownership of the