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A lessee account for a capital lease if at its inception the lease meets any four criteria; the lease transfers ownership of property to the lease by the end of the lease term ,the lease contains an option to purchase the property at a arraign price, the lease is 75% or more the estimated economic life of the property or If the present value exceeds the fair value of the leased property or items at the inception of the lease, the amount that was recorded for the asset should be the fair value. C. Tit a lease being classified as capital, the lessee records it both as an asset and liability at the amount equal to the present value of the minimum lease payment over the lease term. The asset must depreciate in a manner consistent with the lessee’s normal policy. D. Von should first lease as a capital lease because the lease term is more Han 75% of the estimated economic life of the machine. Therefore von should classify the second lease as a capital lease because the lease contains a bargain purchase option. Exercise 3-3 (15 minutes) a. Lessee would account for a capital lease as an asset and an obligation at the inception of the lease.
Rental payments during the year would be allocated between a reduction in the obligation and interest expense. The asset would be amortized in a manner consistent with the lessee’s normal depreciation for owned assets and except that in some cases the period of amortization would be the lease term. . In an operating lease no asset or obligation would be recorded. This would normally use rental on an operating lease and would charge expenses over the term period of the lease. Rental expenses would be recognized as a straight-line basis, unless systematic or rational basis is more beneficial, in which case the basis would be used.
Exercise 3-5 (25 minutes) Many companies have a meager debt ratio, even when a company has or shows little to none in debt on its balance sheet it can have a number of long, term liabilities. This can reflect on certain areas of the company such as; A company’s unfunded postmistresses liabilities, which often are not recorded on the balance sheet, however show on the company disclosed notes. Lease commitments which are very detailed in the companies notes are not recorded on the company’s balance sheet either.
This could be a critical problem for the company if they were to expand by leasing instead of buying property. Many companies guarantee the debt of another company. Typically a unconsolidated lease subsidiary, although this is disclosed in the company notes the debt which is real and can be large is not recorded on the balance sheet. Also on the Off balance sheet debt such as industrial bonds or pollution control financing where a municipality sells tax free bonds guaranteed for payment are cases were debt free balance sheet could look much more worse if these were not recorded.
Problem 3-1 (30 minutes) a. 1. $200 million 2. As the maturity date draws loser the liability will be shown at increasingly larger amounts to show the accrual of interest that will come due at the maturity date. 3. The annual journal entry is: [Note: No cash is involved since it is a zero coupon note. ] b. Please provide a 1 paragraph explanation . $28 million amount will be paid out; this amount will include the $6. 5 million of interest implicit in the leases. D. Note 10 reports that financial statements of the lease footnote.
The lease payments will be expensed over the years. Problem 3-3 (30 minutes) a. A lease should be classified as a capital lease when transferring substantially all of its benefits and its risk the ownership of the property by meeting any one of the four criteria for classifying a lease as a capital lease Specifically: Lease J should be classified as capital lease, because the lease term is equal to 0% of the estimated economic life of the equipment, which exceeds the 75% or more criterion.
Lease K should be classified as capital because the lease contains bargain purchase option. Lease L should be classified as operating because it does not have any of the four classifications a lease with capital would have. B. Barman records the following liability amounts at inception: For Lease J, the records as a liability at the inception of the lease an amount is equal to the present value at the beginning of the lease term of minimum lease payments during the lease term, excluding the cost of insurance, maintenance and taxes to be paid by the lesser.
For Lease K, Barman records as a liability at the inception of the lease an amount determined in the same way as lease J. The payment called for bargain purchase option should be included in the minimum lease payment. For Lease L, no record of liability at the inception Of the lease. C. Barman records the Mills as follows: For Lease J, Barman allocated each minimum lease between a reduction to liability and interest expenses. This produced a constant periodic rate of interest on the remaining balance of the liability. For Lease K, Barman
Allocated each minimum lease payment just like he did in lease J. For Lease L, Barman charged rental payments to the rental expense as they became payable. D. Both operating and capital leases represent economic liabilities; they both require commitment to make changes and fixed payments. Many companies can structure leases as operating leases which avoid balance sheets. If the assets are used to generate revenues they should be considered in ratios like return on assets and other measures of financial performance.