On January 1, 2011, Lani Company entered into a noncancelable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Lani by the end of the lease term. The term of the lease is eight years. The minimum lease payment made by Lani on January 1, 2011, 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. Required:
a. Briefly discuss four criteria used for determining if a lease is to be treated as a capital lease? How are the income statement and balance sheet affected?
b. 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.
c. How should Lani account for this lease at its inception and determine the amount to be recorded?
d. What expenses related to this lease will Lani incur during the first year of the lease, and how will they be determined?
e. How should Lani report the lease transaction on its December 31, 2011, balance sheet?
Milton Corporation entered into a lease arrangement with James Leasing Corporation for a certain machine. James’s primary business is leasing, and it is not a manufacturer or dealer. Milton will lease the machine for a period of three years, which is 50 percent of the machine’s economic life.
James will take possession of the machine at the end of the initial three year lease and lease it to another, smaller company that does not need the most current version of the machine. Milton does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.
Milton’s incremental borrowing rate is 10 percent, and the implicit rate in the lease is 81⁄2 percent. Milton has no way of knowing the implicit rate used by James. Using either rate, the present value of the minimum lease payment is between 90 percent and 100 percent of the fair value of the machine at the date of the lease agreement.
James is reasonably certain that Milton will pay all lease payments, and because Milton has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by James.
a.With respect to Milton (the lessee), answer the following.
i. What type of lease has been entered into? Explain the reason for your answer.
ii. How should Milton compute the appropriate amount to be recorded for the lease or asset acquired?
iii. 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?
iv. What disclosures must Milton make regarding this lease or asset?
b.With respect to James (the lessor), answer the following.
i. What type of leasing arrangement has been entered into? Explain the reason for your answer.
ii. How should this lease be recorded by James, and how are the appropriate amounts determined?
iii. How should James determine the appropriate amount of earnings to be recognized from each lease payment?
iv. What disclosures must James make regarding this lease?
On January 2, 2011, Grant Corporation leases an asset to Pippin Corporation under the following conditions:
1. Annual lease payments of $10,000 for twenty years.
2. At the end of the lease term the asset is expected to have a value of $2,750.
3. The fair market value of the asset at the inception of the lease is $92,625.
4. The estimated economic life of the lease is thirty years.
5. Grant’s implicit interest rate is 12 percent; Pippin’s incremental borrowing rate is 10 percent.
6. The asset is recorded in Grant’s inventory at $75,000 just prior to the lease transaction.
a. What type of lease is this for Pippin? Why?
b. Assume Grant capitalizes the lease. What financial statement accounts are affected by this lease, and what is the amount of each effect?
c. Assume Grant uses straight-line depreciation. What are the income statement, balance sheet, and statement of cash flow effects for 2011?
d. How should Grant record this lease? Why? Would any additional information be helpful in making this decision?
e. Assume that Grant treats the lease as a sales-type lease and the residual value is not guaranteed by Pippin. What financial statement accounts are affected on January 2, 2011?
f. Assume instead that Grant records the lease as an operating lease and uses straight-line depreciation. What are the income statement, balance sheet, and statement of cash flow effects on December 31, 2011?
To meet the need for its expanding operations, Johnson Corporation obtained a charter for a separate corporation whose purpose was to buy a land site, build and equip a new building, and lease the entire facility to Johnson Corporation for a period of twenty years. Rental to be paid by Johnson was set at an amount sufficient to cover expenses of operation and debt service on the corporation’s twenty-year serial mortgage bonds. During the term of the lease, the lessee has the option of purchasing the facilities at a price that will retire the bonds and cover the costs of liquidation of the corporation.
Alternatively, at the termination of the lease, the properties will be transferred to Johnson for a small consideration. At the exercise of the option or at the termination of the lease, the lessor corporation will be dissolved.
a. Under certain conditions, generally accepted accounting principles provide that leased property be included in the balance sheet of a lessee even though legal title remains with the lessor.
i. Briefly discuss the conditions that would require financial statement recognition of the asset and the related liability by a lessee.
ii. Briefly describe the accounting treatment that should be employed by a lessee under the conditions you described in your answer to part (i).
b. Unless the conditions referred to in (a) are present, generally accepted accounting principles do not embrace asset recognition of leases in the financial statements of lessees. However, some accountants do advocate recognition by lessees that have acquired property rights. Explain what is meant by property rights and discuss the conditions under which these rights might be considered to have been acquired by a lessee.
c. Under the circumstances described in the case, how should the Johnson Corporation account for the lease transactions in its financial statements? Explain your answer.
a. Briefly discuss four criteria used for determining if a lease is to be treated as a capital lease? How ar