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29
Chapter 21
(a)
Memorandum
To: Eric Conner and Phil Martin, CM2
From: L. Harbach
Re: Leases
Date: February 13, 2013
According to FASB ASC 840-10-25-1, the lease proposal offered by Tyler
Leasing Company meets at least one of the four capital lease criteria:
1. Title transfers? NO
2. Bargain purchase option? NO
The asset is required to be capitalized (recorded) on the books at $685,000,
along with a lease liability for the same amount. The lessor (Tyler) requires a
guaranteed residual value for two reasons:
(1) It protects the lessor against any loss in estimated residual value, thereby
ensuring the lessor its desired rate of return on investment.
(2) A guaranteed residual value is considered a minimum lease payment and
See my calculations on the next page, which show debt-to-equity analysis for
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Debt-to-Equity Analysis
Assuming an operating lease, and that payment has been deducted from cash
and equity:
Journal entry on January 1, 2013:
DR CR
= 1.66
Assuming a capital lease:
Journal entries on January 1, 2013:
Journal entries on December 31, 2010:
Interest Expense 53,934
Interest Payable 53,934
($685,000 $145,661) x 10% = $53,934
Depreciation Expense 112,000
In the early years, the interest expense and depreciation expense related to a
capital lease exceed the lease expense recorded in an operating lease. The
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Additional Activity: Extend your accounting knowledge
Memorandum
To: Eric Conner and Phil Martin, CM2
From: L. Harbach
Re: Third-Party Guarantors
Date: February 15, 2013
If the residual value is not guaranteed by the lessee, the lease fails all four lease
capitalization criteria. In that case, it is classified as an operating lease.
Tyler Leasin not guaranteed:
1. Title transfers? NO
Lease proposal: 4.16986
$145,661 payments (PV-AD, i = 10%, n = 5) = $607,385
$125,000 GRV (PV$1 i = 10% n = 5) = 77,615***
Present value of the minimum lease payments = $607,385
By not guaranteeing the residual value, CM2 would benefit, since the lease
expense would be less than the total interest and depreciation expense in a
capital lease. However, the lessor, Tyler, will not agree to an unguaranteed
estimated residual value at the end of the lease term.