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Proper Accounting Treatment for Leases

Your accounting firm has been hired to consult with the Graduate Manufacturing Company (GMC). GMC is preparing its annual financial statements as of December 31.

GMC entered into five separate lease arrangements at the beginning of the year. Each lease provides for annual lease payments at the beginning of each year. For each lease, GMC recorded the initial lease payment on January 2nd by debiting Lease Expense and crediting Cash for the lease payment amount.

You have been assigned to prepare a written report to be presented to GMC's senior management that explains the proper accounting treatment for each lease.

For each lease, you should include the following:

1. Any accounting entries needed to correctly state the accounting treatment for each lease. Keep in mind that GMC has already debited Lease Expense for the year's lease payment and you may have to include a correction for that entry.
2. A discussion of why these accounting entries are appropriate and necessary, from accounting theory and regulatory standpoints.
3. References to the appropriate accounting authority supporting your conclusions using the FASB's ASC suggested reference notation that can be found in the ASC Notice to Constituents, to the section level.

Lease 1

GMC leased a mid-size computer from the Wiz Bang Computer Company to serve as their network hub. The following facts apply to this lease:

Lease term: 5 years
Annual lease payment: $18,000
Computer's fair market value at the inception of the lease: $100,000
Computer's anticipated economic life: 6 years
GMC's borrowing rate: 9%
Present value factor for an annuity due for 5 periods at 9%: 4.23975

At the end of the lease term, the computer must be returned to Wiz Bang.
Lease 2

GMC leased a luxury car for the use of the company's president from the local Lexus dealership. The following facts apply to this lease:

Lease term: 3 years
Annual lease payment: $30,000
Ca'rs fair market value at the inception of the lease: $120,000
Car's anticipated economic life: 7 years
GMC's borrowing rate: 9%
Present value factor for an annuity due for 3 periods at 9%: 2.75911

At the end of the lease, the car can be purchased for its estimated fair market value or it must be returned to the dealer.

Lease 3

GMC leased a computerized industrial laser cutting machine from the Coherent Light Company to custom produce parts for one of their products. The following facts apply to this lease:

Lease term: 7 years
Annual lease payment: $10,000
Machine's fair market value at the inception of the lease: $60,000
Machine's anticipated economic life: 10 years
GMC's borrowing rate: 9%
Present value factor for an annuity due for 7 periods at 9%: 5.48592

At the end of the lease, the machine can be purchased for its estimated fair market value or it must be returned to Coherent Light.

Lease 4

GMC leased a diesel powered generator from the Always On Company for its administrative building that automatically starts whenever power is interrupted to the. The following facts apply to this lease:

Lease term: 10 years
Annual lease payment: $25,000
Generator's fair market value at the inception of the lease: $190,000
Generator's anticipated economic life: 14 years
GMC's borrowing rate: 9%
Present value factor for an annuity due for 10 periods at 9%: 6.99525

At the end of the lease, the generator can be purchased for $1 or it can be returned to Coherent Light.

Lease 5

GMC leased a video conferencing system from the I See You Company so that it can hold meetings with management from its various factories without incurring travel expenses. The following facts apply to this lease:

Lease term: 4 years
Annual lease payment: $44,000
Machine's fair market value at the inception of the lease: $175,000
Machine's anticipated economic life: 6 years
GMC's borrowing rate: 9%
Present value factor for an annuity due for 4 periods at 9%: 3.53130

At the end of the lease, the system becomes GMC's property.

As you prepare your report, keep in mind that your client is not an accountant and, consequently, your description should not utilize technical accounting jargon. It should be clearly written in layman's terms and logically explain the rationale behind the accounting entries. Do not simply copy verbiage from a textbook or pronouncement.

Use all of the resources available to you.

Grading will be based upon:

Accuracy of the accounting entries (25%)
Clarity, completeness and accuracy of the discussion (25%)
Accuracy of the references cited (25%)
Overall professionalism and appearance of the report (25%)

Solution Preview

ANSWERS
Please see attached file for answers.

The classification of a lease into operating or capital directly affects how that lease and related expenses are recorded in the books of the lessee. First, according to the
Financial Accounting Standards Board if a lease meets any one of the following four conditions should be classified as a capital lease, otherwise it is recorded as an operating lease.

The four conditions are:
1. lease life exceeds 75% of the life of the asset,
2. there is a transfer of ownership to the lessee at the end of the lease term
3. there is an option to purchase the asset at a "bargain price" at the end of the lease term, and
4. the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.

Second, the following are the standard accounting entries for each type of leases.
Operating Lease Capital Lease
Date of lease contract No entries Leased equipment xxx
Lease obligation xxx
Periodic lease payment Rent expense xxx
Cash xxx Lease obligation xxx
Interest expense xxx
Cash xxx
Depreciation No entries Depreciation expense xxx
Accumulated depreciation xxx

Third, the table below compares how each of the five leases that Graduate Manufacturing Company (GMC) entered into performs using the four conditions of capital leases enumerated above.
Lease Life (more than 75%) Transfer of Ownership Bargain Price Present Value (more than 90%) Type of Lease
Lease 1 Yes No NA No Capital
Lease 2 No No No No Operating
Lease 3 No No No Yes Capital
Lease ...

Solution Summary

This solution explains the characteristics of a lease and the four conditions for a capital lease. It also evaluates the different leases for accounting entries, appropriateness and regulatory standpoints.

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