Question

P5-7 The Mainor School District is about to establish a 30-machine computer lab. It is considering six alternative means of acquiring and financing the machines:
1. Buy the machines outright; cost will be $60,000.
2. Buy the machines and finance them with a $60,000, three-year, 10 percent interest term note. The district will repay the note and pay the entire interest with a single payment of $79,860 when the note matures.
3. Buy the machines and finance them with a $60,000, three-year, 10 percent interest, installment note. The district will repay the note (plus interest) in three endof-year installments of $24,127 each.
4. Lease the equipment under a standard operating lease. The district will make three end-of-year lease payments of $24,127 each.
5. Lease the equipment under an operating lease, but pre-pay the entire rent ($60,000) in advance.
6. Lease the equipment, but structure the lease so that it satisfies the criteria of a capital lease. The district will make three $24,127 end-of-year lease payments. The district estimates that the equipment has a useful life of three years.

a. Prepare a table in which for each alternative you indicate the net expenditure that the district would record in its general fund in the year of purchase and the following two years. Ignore any expenditures that are offset by ‘‘other financing sources.’’ For the fifth option (the operating lease with the rent paid in advance), assume first that the district accounts for prepayments on the purchases basis and then that it accounts for them on the consumption basis.

b. Determine the present value (using a discount rate of 10 percent) of the cash payments under each option.

c. Comment on any incentives that district officials might have either to spread out the payments over the three-year period (either by a lease or borrowing arrangement) or to postpone the full payment until the third year, rather than to pay for the computers entirely in the year of acquisition.

d. Comment on any significant differences in how the six options would be accounted for in government-wide statements instead of governmental fund statements. How would each year’s reported expense be determined?

Answer 1

a) & b)

all figures in USD ($)	Payment / Installments / Lease payments               (3-year period)	Total payment at Maturity	Present value at 10%
Year 1	Year 2	Year 3
1. Buy the machines outright	60,000	-	-	-	60,000
2. Buy the machines and finance - A	-	-	-	79,860	66,000
3. Buy the machines and finance - B	24,127	24,127	24,127	72,381	66,000
4. Lease the equipment - A	24,127	24,127	24,127	72,381	66,000
5. Lease the equipment - B	60,000	-	-	-	60,000
6. Lease the equipment - C	24,127	24,127	24,127	72,381	66,000

c)

The district officials need to consider a variety of factors with respect to the expenses for the equipments. As the expense for outright buying the equipment is $60,000 it will be a huge outflow in the single year and will be difficult to cope with if the other budgeted expenses for the year aren't met. The officials might consider a plan for deferred expenses over the assigned life span of the equipment as it won't be much of a burden in the single year's budget. Considering the equiment is a depreciating asset and will also require some maintenance over a period of time, it is highly unlikely that the district officials consider a plan to make the entire payment either at the start or at the end of the three year period.Thus 3rd, 4th and 6th plans are the ones most likely to be considered by the district officials to avoid sudden cash outflow of a huge amount.

d)

Option 1 would capitalize the entire amount of $60,000 in the first year itself with no depreciation benefit but a possible tax benefit. Option 2 would capitalize the entire amount of $60,000 in the third year with no depreciation benefit but a possible tax benefit. Option 3 will debit the installments over a three year period with a possible tax benefit. Option 4 spread the outflows in three years with both depreciation and tax benefit. Option 5 will have a cash outflow in the third year with a possible tax benefit. Option 6 will have cash outflow over a three year period with both depreciation and tax benefits.