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Johnson Corporation leases

To meet the need for its expanding operations, Johnson Corporation obtained a charter for a separate corporation whose purpose was to buy a land site, build and equip a new building, and lease the entire facility to Johnson Corporation for a period of twenty years. Rental to be paid by Johnson was set at an amount sufficient to cover expenses of operation and debt service on the corporation's twenty-year serial mortgage bonds. During the term of the lease, the lessee has the option of purchasing the facilities at a price that will retire the bonds and cover the costs of liquidation of the corporation.

Alternatively, at the termination of the lease, the properties will be transferred to Johnson for a small consideration. At the exercise of the option or at the termination of the lease, the lessor corporation will be dissolved.

Required:
a. Under certain conditions, generally accepted accounting principles provide that leased property be included in the balance sheet of a lessee even though legal title remains with the lessor.

i. Briefly discuss the conditions that would require financial statement recognition of the asset and the related liability by a lessee.

ii. Briefly describe the accounting treatment that should be employed by a lessee under the conditions you described in your answer to part (i).

b. Unless the conditions referred to in (a) are present, generally accepted accounting principles do not embrace asset recognition of leases in the financial statements of lessees. However, some accountants do advocate recognition by lessees that have acquired property rights. Explain what is meant by property rights and discuss the conditions under which these rights might be considered to have been acquired by a lessee.

c. Under the circumstances described in the case, how should the Johnson Corporation account for the lease transactions in its financial statements? Explain your answer.

Solution Preview

i. Briefly discuss the conditions that would require financial statement recognition of the asset and the related liability by a lessee.

The criteria for capitalizing a lease as assets purchased through financing (instead of leased asset) include:

Transfer of ownership: If the title reverts to the lessee (user) at the end of the lease, it is considered an asset purchased through financing.

Bargain-Purchase Option: If the lease provides for a below market purchase at the end of the lease, it is considered an asset purchased through financing.

Economic Life Test: If the lease period is equal or greater than 75% of the useful life, it is considered an asset purchased through financing.

Recovery of Investment Test: If the present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the asset, it is considered an asset purchased through financing.

If any one of these is ...

Solution Summary

Your tutorial is 426 words and explains the four criteria for capital leases, and applies those criteria to the Johnson Corp's transaction. The response also comments on capitalizing "right to use" assets and the idea behind the push to show these in the financial statements.

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