Question

He Park Company owns 80% of the outstanding common stock of the Sea Company. Park is about to lease a machine with a 5-year life to the Sea Company. The lease would begin January 1, 20X3.

Required:

Explain the adjustments that will be required in the consolidation process if each of the following occurs.

• a. The lease is an operating lease.
• b. The lease is a direct financing lease with a bargain purchase option.
• c. The lease is a sales-type lease with a bargain purchase option. When completed submit your assignment to the appropriate area.

Answer 1

• When the lease is an operating lease

Typically, the procedure for consolidation for any intercompany lease is entirely dependent on the initial lease recording by the two companies. For situations where the lease is an operating lease, the purchase of an asset is recorded by the leaser, which is then depreciated. Further, in such occurrences, the rent revenue would be recorded by the lessor and the rent cost by the lessee. Also, the associated expenditure and rent revenue will be erased throughout the consolidation process in cases where the operational lease was used for an intercompany lease. Consequently, the asset and related accumulation in this intercompany leasing scenario would be classed as regular productive assets instead of an operational lease.

• When The lease is a direct financing lease with a bargain purchase option

The lessor would transfer the asset under a direct finance lease, and the lessee will receive a long-term receivable. Also, the lessor will get future interest revenue upon the payments becoming due. Thus, there lacks any immediate profit or loss incurred by the lessor. Ultimately, at the end of this lease, the lessor may contemplate a bargain buy option. However, the lessee is not compelled to employ the lease duration and would deduct the capitalized cost during the asset's life. To do away with intercompany transactions, consolidated processes would be considered necessary after each period. The intercompany debt, income, interest expenditure, and accruals would have to be duly extinguished.

• The lease is a sales-type lease with a bargain purchase option

Typically, if the lessor transfers the asset to the lessee through a sales-type lease, a profit or loss is usually recorded. Either is determined by the underlying difference between the asset's fair value when the lease period starts and the cost of the asset bought by the lessor. Then, consolidation processes would not make it possible to record the asset's profit or loss. However, they must be postponed and amortized throughout the lessee's duration of use of the asset. But if the lease includes a bargain buy or bargain renewal option, the asset's useful life will be utilized instead of the lessee's usage period. The sole difference between the direct financing lease and the other consolidation techniques is the deferral and amortization of the gain or loss. The lessor's income distribution schedule would have to disclose the deferral of the initial loss or gain in the year of sale and amortize it every year throughout the asset's useful life. The depreciation expense account would need to be amended to reflect the initial selling profit. The initial sales profit or loss would need to be adjusted on the partly consolidated worksheet.