Essay: Lease You are the chief financial officer at SD International (SDI). SDI
ID: 2771403 • Letter: E
Question
Essay: Lease
You are the chief financial officer at SD International (SDI). SDI is a small but growing computer hardware retailer. The company plans to purchase new buildings this year. However, SDI has an existing commercial loan with National Commercial Bank (NCB). One of the conditions of the existing loan was for SDI to maintain interest coverage ratio (operating income/interest expense) of two or higher.
Below is the projected data for next year.
$7,500,000
Interest expense on existing loan
3,500,000
New buildings’ cost
25,000,000
If SDI borrows the $25 million needed to finance the new buildings, the increased interest expense will cause SDI to be in violation of the interest coverage constraint.
The controller suggested an accounting solution to this dilemma: lease the new buildings, carefully constructing the lease agreements so that the leases will be accounted for as operating leases. The leasing arrangements will be economically similar to purchase of the buildings with borrowed money, but the annual payments will be reported as rent expense instead of interest expense. Accordingly, the interest coverage loan covenant will not be violated. You were involved in the negotiation of NCB‘s loan. Therefore, you know that the intent of the loan covenant was to prevent SDI from incurring large fixed obligations that might endanger the repayment of the NCB loan. Operating lease payments are fixed obligations, just like interest payments, and you are uneasy about using this accounting trick to get around the loan covenant. However, there does not seem to be any other solution. Write about what you would do.
1. Explain the theoretical basis for requiring lessees to capitalize certain long-term leases.
2. Explain how SDI should account for the lease.
Your well-written paper must be 2-3 pages, in addition to title and reference pages. The paper should be formatted according to the APA Requirements. Any supporting calculations should be inserted in a table in your Word document. Do not submit two separate documents, as only one document can be accepted.
Operating income
$7,500,000
Interest expense on existing loan
3,500,000
New buildings’ cost
25,000,000
Explanation / Answer
A liability is an obligation to pay funds in the future (for example debt with a bank).
Operating income 75,00,000 Interest expense on existing loan 35,00,000 New buildings’ cost 2,50,00,000 Interest coverage ratio 2.14285714A liability is an obligation to pay funds in the future (for example debt with a bank).
A long term lease is also an obligation to pay funds in the future and so, some argue, should be shown as an liability also. Otherwise when looking at the balance sheet what is essentially a commitment to pay funds in the future is not recorded anywhere. In terms of the asset itself it is being held long term and so the organisation has the rights and benefits of that asset for a long period of time, just as it would if it had bought it outright. If the organisation uses the asset in this way it should be recorded as an asset on the balance sheet. For accounting purposes of the lessee, all leases may be classified as operating leases or capital leases. For a lease to be recorded as a capital lease, the lease must be noncancelable and meet one of the following four criteria: a. The lease transfers ownership of the property to the lessee at the end of the lease. b. The lease contains a bargain purchase option. c. The lease term is equal to 75% or more of the estimated economic life of the leased property. d. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property. If the lease meets none of the four criteria, the lease should be classified and accounted for as an operating lease. Theoretical basis for requiring lessees to capitalize certain long-term leases 1 In discussing the advantages of leasing arrangements, advocates point out that leasing allows for: (a) 100% financing, (b) protection against obsolescence, (c) flexibility, (d) less costly financing, (e) tax advantages, and (f) off-balance sheet financing. 2 A variety of opinions exist regarding the manner in which certain long-term lease arrangements should be accounted for. These opinions range from total capitalization of all long-term leases to the belief that leases represent executory contracts that should not be capitalized. The FASB requires capitalization of lease arrangements that are similar to installment purchases. In short, lease arrangements that transfer substantially all of the risks and rewards of ownership of property should be capitalized by the lessee. SDI should classify it as an operating lease so that it would not violate the contract with the NCB bank Also its possible that with the business expansion it would more easily pay of NCB's debts Operating Leases for Lessees 1 In accounting for an operating lease, the lessee would use the accounting method known as the operating method. When the lessee uses the operating method, the periodic rent associated with the lease is recognized in the period benefited by the leased asset. Under this method, the commitment to make future rental payments is not recognized in the accounts. Only footnote recognition is given to the commitment to pay future rentals. The journal entry the lessee would make to record operating lease payments includes a debit to Rent Expense and a credit to Cash.Related Questions
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