Question

C 20-14

Capital Lease Issues

Situation

LO 20.1 LO 20.3 Cliborn Retail Company negotiated a lease for a retail store in a new shopping center that included 30 stores. The accountant for Cliborn, Gail Naugle, was given the lease agreement to analyze. She looked into whether the lease was a capital lease. The lease did not include a transfer of ownership or an option to purchase. The lease term was for 20 years, and the present value of the minimum lease payments was $100,000. Unsure of the fair market value of the property or its life, she called the lessor's controller.

“That is easy,” he replied. “There is no fair value because we would never sell a single store in a shopping center. And, let's see, 20 years divided by 75% is about 27 years, so the life of the property must be at least that much.”

Directions

1. Assuming that you are Gail, research the generally accepted accounting principles and prepare a short memo to the controller of Cliborn that summarizes how to classify the lease. Cite your reference and applicable paragraph numbers.

Answer 1

Answer:-

To:                   Controller, Cliborn Company

From:               Gail Naugle, Accountant

I have researched the issue of the appropriate classification of the lease under GAAP.  According to FAS 13, par. 7, a lease is capitalized when any one of four conditions is present:

a.         The lease transfers ownership of the property to the lessee at the end of the life of the lease.

b.         The lease contains a bargain purchase option.

c.         The lease term is equal to 75% or more of the estimated economic life of the leased property.

d.         The present value at the beginning of the lease term of the minimum lease payments, excluding executory costs, equals or exceeds 90% of the excess of the fair value of the property to the lessor.

The lease for the retail store clearly does not meet either criterion (a) or (b).

The application of criterion (d) raises problems because individual stores in multi-store retail environments are not sold individually and therefore the fair value of the property to the lessor is not known.  It would be possible to impute a value based on differential rents charged to the various stores, but we do not have that information available to us and I doubt that the lessor would tell us.  Also such rents will be affected by many variables other than the intrinsic value of the space, including the length of the lease, contingent rentals, advertising commitments etc.  Therefore, it is my conclusion that to try to impute a value of the property to the lessor would result in a value that was not reliable, and also perhaps not relevant.

Therefore criterion (c) is the only one left to apply to this lease.  Since real estate is commonly depreciated over lives much greater than 30 years and the shopping center is new, the 20 year life of the lease is less than 75% of any reasonable life assigned to the property.  Therefore, the lease is an operating lease.

Note that the four criteria are supposed to measure whether substantially all the risks and benefits of ownership have passed.  However, there is no room to use judgment in applying this broad principle.  The four specific criteria are all that may be applied.