Question

On January 1, 2021, SantanaBrewing, a lessee, entered into three non-cancelable leases for new equipment, Lease O, Lease M, and Lease G. None of the three leases transfers ownership of the equipment to Santana Brewing at the end of the lease term. The following information is specific to each lease. 

1. Lease O does not contain a bargain purchase option. 

2.  Lease M contains a bargain purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.

3.  Lease G does not contain a bargain purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.

   Required: a. What amount, if any, should Santana Brewing record as a liability at commencement of the lease for each of the three leases above? Please explain your answer! (10 points) b. Assuming that the lease payments are made on a straight-line basis, how should Santana Brewing record each lease payment for each of the three leases above? Please explain! (10 points)
   

Answer 1

a. To determine the amount that Santana Brewing should record as a liability at the commencement of each lease, we need to consider whether the lease transfers ownership of the equipment to Santana Brewing at the end of the lease term and whether a bargain purchase option exists.

Lease O: Since Lease O does not contain a bargain purchase option and does not transfer ownership of the equipment to Santana Brewing at the end of the lease term, it is classified as an operating lease. In this case, Santana Brewing would record the present value of the lease payments as a liability at the commencement of the lease.

Lease M: Lease M contains a bargain purchase option. If the exercise of the bargain purchase option appears reasonably certain, Santana Brewing would consider the lease as a finance lease. In this case, Santana Brewing would record the lower of the present value of the lease payments or the fair value of the underlying equipment as a liability at the commencement of the lease.

Lease G: Similar to Lease O, Lease G does not contain a bargain purchase option and does not transfer ownership of the equipment to Santana Brewing at the end of the lease term. Therefore, it would also be classified as an operating lease. Santana Brewing would record the present value of the lease payments as a liability at the commencement of the lease.

b. Assuming that the lease payments are made on a straight-line basis, Santana Brewing would record each lease payment as follows:

Lease O: For an operating lease like Lease O, Santana Brewing would record each lease payment as an expense in its income statement. The liability recorded at the commencement of the lease would be reduced as the lease payments are made.

Lease M: If Lease M is classified as a finance lease due to the reasonably certain exercise of the bargain purchase option, Santana Brewing would allocate each lease payment between interest expense and reduction of the liability. The interest expense would be calculated based on the effective interest method, and the reduction of the liability would be recorded as a reduction of the lease liability.

Lease G: Similar to Lease O, for Lease G classified as an operating lease, Santana Brewing would record each lease payment as an expense in its income statement. The liability recorded at the commencement of the lease would be reduced as the lease payments are made.

It's important to note that the specific terms and conditions of the leases, such as interest rates, payment frequency, and other contractual provisions, may affect the precise calculations and journal entries. Therefore, it's recommended to consult with accounting professionals or refer to accounting standards (such as ASC 842 for US GAAP or IFRS 16) for detailed guidance on lease accounting and reporting.