Communication Case 15–2 Classification issues; lessee accounting; group interact

Question

Communication Case 15–2 Classification issues; lessee accounting; group interaction

LO15-1, LO15-2, LO15-3, LO15-6, LO15-7

Interstate Automobiles Corporation leased 40 vans to VIP Transport under a four-year noncancelable lease on January 1, 2018. Information concerning the lease and the vans follows:

a.   Equal annual lease payments of $300,000 are due on January 1, 2018, and thereafter on December 31 each year. The first payment was made January 1, 2018. Interstate’s implicit interest rate is 10% and known by VIP.

b. VIP has the option to purchase all of the vans at the end of the lease for a total of $290,000. The vans’ estimated residual value is $300,000 at the end of the lease term and $50,000 at the end of 7 years, the estimated life of each van.

c.   VIP estimates the fair value of the vans to be $1,240,000. Interstate’s cost was $1,050,000.

d. VIP’s incremental borrowing rate is 9%.

e.   VIP will pay the maintenance fees not included in the annual lease payments of $1,000 per year. The depreciation method is straight-line.

Your instructor will divide the class into two to six groups depending on the size of the class. The mission of your group is to assess the proper recording and reporting of the lease described.

Required:

1. Each group member should deliberate the situation independently and draft a tentative argument prior to the class session for which the case is assigned.

2. In class, each group will meet for 10 to 15 minutes in different areas of the classroom. During that meeting, group members will take turns sharing their suggestions for the purpose of arriving at a single group treatment.

3. After the allotted time, a spokesperson for each group (selected during the group meetings) will share the group’s solution with the class. The goal of the class is to incorporate the views of each group into a consensus approach to the situation.

Specifically, you should address:

a.   Identify potential advantages to VIP of leasing the vans rather than purchasing them.

b. How should the lease be classified by VIP? by Interstate?

c.   Regardless of your response to previous requirements, suppose VIP recorded the lease on January 1, 2018, as a finance lease in the amount of $1,100,000. What would be the appropriate journal entries related to the finance lease for the second lease payment on December 31, 2018?

Explanation / Answer

a.     Leasing is giving /receiving on rent ,any capital asset, for use in the business. The giver is the owner of the leased asset, called the lessor who receives lease rental revenues which includes interests at the agreed rates. The person who receives the asset, for use in his business,for an agreed time period, is the lessee. He has to pay periodic lease rentals to the lessor--which include payment towards interest as well as the principal lease amount. There are many advantages to the lessee(here, VIP) , in leasing the asset rather than purchasing: 1. VIP need not worry about any immediate spending --but can enjoy the usage of the asset ,to better his business. 2. Leasing is comparatively less cumbersome than owning an asset --so initial delays in enquiry,obtaining quotes, comparing with peer-groups--- all time-consuming activities ,can be given the go-by. 3. Total money value commitment is known to the lessee ,before-hand --- which is also lessened to the extent of residual value,intact in the asset 4. VIP gets to use the asset without any debt liability on the balance sheet. 5. Lease rental expenses ,including interest , are tax-deductible 6. As the lessee does not post any debt in the books, his borrowing capacity is still intact. 7. VIP need not fear the risk of the asset getting outdated or obsolete as he has the option to replace the asset with the latest one available in the market.--ie. His chioces or more than for the purchaser. 8. Amounts to almost an additional source of finance& cheaper one too---than purchase. b. How should the lease be classified by VIP---- Lessee Criteria for capital leases(meeting any one of the following): 1. Transfer of ownership of the lease-asset to the lessee at end of the lease term. 2.The lease contains a bargain purchase option 3.The lease term is equal to 75% or more of the economic life of the leased asset 4.The present value of minimum lease payments as at the beginning of the lease term equals or exceeds 90% of the fair value of the lease-asset If the lease meets, even any one of the above criteria,it is a capital lease. If, not even one of these is met, it is treated as an operating lease. As far as VIP-- the lessee is concerned- Point no.1 is not specified 2. Bargain purchase option is available to the lessee at end of the term( 290000

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