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Distinguish Between Capital Lease and Operating Lease

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Milton Corporation entered into a lease arrangement with James Leasing Corporation for a certain machine. James's primary business is leasing, and it is not a manufacturer or dealer. Milton will lease the machine for a period of three years, which is 50 percent of the machine's economic life.

James will take possession of the machine at the end of the initial three year lease and lease it to another, smaller company that does not need the most current version of the machine. Milton does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.

Milton's incremental borrowing rate is 10 percent, and the implicit rate in the lease is 81�2 percent. Milton has no way of knowing the implicit rate used by James. Using either rate, the present value of the minimum lease payment is between 90 percent and 100 percent of the fair value of the machine at the date of the lease agreement.

James is reasonably certain that Milton will pay all lease payments, and because Milton has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by James.

Required: From each part (a & b) answer two questions. For example, ai & aii and bi & biii.

a.With respect to Milton (the lessee), answer the following.

i. What type of lease has been entered into? Explain the reason for your answer.

ii. How should Milton compute the appropriate amount to be recorded for the lease or asset acquired?

iii. What accounts will be created or affected by this transaction, and how will the lease or asset and other costs related to the transaction be matched with earnings?

iv. What disclosures must Milton make regarding this lease or asset?

b. With respect to James (the lessor), answer the following.

i. What type of leasing arrangement has been entered into? Explain the reason for your answer.

ii. How should this lease be recorded by James, and how are the appropriate amounts determined?

iii. How should James determine the appropriate amount of earnings to be recognized from each lease payment?

iv. What disclosures must James make regarding this lease?

Solution Preview

Milton Corporation entered into a lease arrangement with James Leasing Corporation for a certain machine. James's primary business is leasing, and it is not a manufacturer or dealer. Milton will lease the machine for a period of three years, which is 50 percent of the machine's economic life.

James will take possession of the machine at the end of the initial three year lease and lease it to another, smaller company that does not need the most current version of the machine. Milton does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term.

Milton's incremental borrowing rate is 10 percent, and the implicit rate in the lease is 81.2 percent. Milton has no way of knowing the implicit rate used by James. Using either rate, the present value of the minimum lease payment is between 90 percent and 100 percent of the fair value of the machine at the date of the lease agreement.

James is reasonably certain that Milton will pay all lease payments, and because Milton has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by James.

Required: From each part (a & b) answer two questions. For example, ai & aii and bi & biii.

a.With respect to Milton (the lessee), answer the following.

i. What type of lease has been entered into? Explain the reason for your answer.
Capital lease. The lease is accounted for by lessee as a capital lease if any of the four following criteria is met: 1) the lease transfers title to the lessee; 2) the lease ...

Solution Summary

This posting comprises of 990 words on account handling for an operating lease described.

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