Question

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.”

Required: please read carefully what is required

A. Prepare a reply to the controller for the scenario presented. Once you have presented a response, decide whether or not a lease or purchase would be the best option for the item being considered for acquisition.

B. Explain how the asset would be accounted for by purchase and what effect it would have on the financial statements.

Answer 1

A.

Memo:

Lease agreement: The given lease agreement is not a capital lease due to the following conditions not fulfilled:

• Lease agreement does not have an option of purchase at the end the the lease period.
• Transfer of ownership to the lessee at the end of the lease agreement.
• The term of lease is greater than 75% of the total life of the asset.
• The PV of lease is greater than 90% of the fair value of the asset.

Upon reviewing the lease agreement, all of the above conditions of a capital lease are not fulfilled as there is no transfer of ownership or a purchase option, the fair value of lease is not given but it is safe to assume that the present value of the lease payments is not greater than 90% and the life of the asset seems to be indefinite as it depends on the management's capability to maintain the asset.

Based on the above analysis, the given lease agreement is an operating lease and not a capital lease.

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B.

The accounting of an operating lease is to debit the operating lease expense and credit cash for the amount of lease payment paid.