Question

Cullumber Company is evaluating a lease arrangement being offered by TSP Company for use of a computer system. The lease is noncancelable, and in no case does Cullumber receive title to the computers during or at the end of the lease term. The lease starts on January 1, 2017, with the first rental payment due on January 1, 2017. Additional information related to the lease is as follows.

Yearly rental		$3,710.00
Lease term		3 years
Estimated economic life		5 years
Purchase option		$3,000 at end of 3 years, which approximates fair value
Renewal option		1 year at $1,500; no penalty for nonrenewal; standard renewal clause
Fair value at inception of lease		$10,200
Cost of asset to lessor		$10,200
Residual value:
Guaranteed		–0–
Unguaranteed		$3,000
Lessor’s implicit rate (known by the lessee)		11%
Executory costs paid by:		Lessor; estimated to be $560 per year (included in rental equipment)
Estimated fair value at end of lease		$3,000

(a) Analyze the lease capitalization criteria for this lease for Cullumber Company. Prepare the journal entry for Cullumber on January 1, 2017. (Credit account titles are automatically indented when the amount is entered. Do not indent manually. Round present value factor calculations to 5 decimal places, e.g. 1.25124 and the final answers to 2 decimal places, e.g. 52.75. If no entry is required, select "No entry" for the account titles and enter 0 for the amounts.)

Jan 1. Debit

Credit

List of Accounts

• Accumulated Depreciation—Capital Leases
• Cash
• Cost of Goods Sold
• Depreciation Expense
• Insurance Expense
• Interest Expense
• Interest Payable
• Interest Receivable
• Interest Revenue
• Inventory
• Leased Equipment
• Lease Liability
• Lease Receivable
• Maintenance and Repairs Expense
• No Entry
• Rent Expense
• Sales Revenue

Answer 1

Accounting:

For Capitalization of lease there are four criteria. They are

S. No	Criteria	Analysis	Result
1	Transfer of title	This lease does not transfer title	Not Met
2	Bargain-purchase option	The option to purchase at the end of the lease is clearly not a bargain	Not Met
3	lease term is a 75% or more of the economic life of the leased asset	The lease term is (3 ÷ 5) = 0.6 or 60%	Not Met
4	The present value of the minimum lease payments is 90% or more of the leased asset’s fair value	Minimum lease payments = (Rental payments – Executory costs) = $3,710 – $560 = $3,150 Present value of min. lease payments = ($3,150 x 2.69005) = $8,473.658 Percentage = $8,473.658 ÷ $10,200 = 0.83075 or 83.07%.	Not Met

Therefore, this lease is accounted for as an operating lease. Therefore the journal entry that Cullumber Company makes on January 1, 2012 is:

Jan. 1, 2017

                              DR          Rent Expense                    $3,710

                              CR                                 To Cash                      $3,710

Analysis:

When companies structure leases to avoid capitalization, the leased assets and the obligation for the Non- cancelable lease payments are “Off-Balance-Sheet.”

As a result, the denominator of the return on assets ratio (ROA = Net income ÷ Average assets) will be understated, and a company will look more profitable than it really is. The debt to total assets ratio (Total debt ÷ Total assets) will be understated, thereby giving the impression that the company is more solvent than is really the case. If companies capitalize differing percentages of their leases, it will be difficult to compare the companies based on ROAs and debt to total asset ratios.

Principles:

The lease criteria are designed to report leases according to their economic substance. Thus, if through a lease arrangement a company controls the risks and rewards of the leased asset, it meets the definition of an asset and should be recognized on the balance sheet. Similarly, the associated liability should be recognized if it represents an unavoidable obligation and thereby meets the definition of a liability. That is, the financial statements faithfully represent (completeness) if they report all assets and liabilities.

Of course, structuring a lease to avoid capitalization detracts from representational faithful reporting of the lease arrangement, which may not be prejudicial.