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:

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.

Reply

To : Cliborn Controller

Date : mm/dd/yy

From : Gail Naugle, Accountant

RE: Lease Classification

After reviewing of the negotiated leased agreement I have come to the conclusion that Cliborn Retail has entered into an operating lease agreement. In order to be classified as an operating lease, the lease cannot have any of the following qualities:

1) The lease transfers ownership of the property to the lessee by the end of the term.

2) The lease will contain a bargain of purchase option.

3) The lease term will be equivalent to 75% or more of the property economic life.

4) The present value of the lease payment is equal to 90% of the fair market value.

The lease does not offer Cliborn the right or option to purchase the property at the end of the lease. If the lease term is 27 years the estimate life of the property is less than 75% of the fair value.  Since the fair value is basically zero the leased space cannot determine the minimum percentage of the lease payment.

The lessor's controller made it clear that the owner will not sell a single unit of the retail property, therefore leasing is our best option.

B.

If the rent is prepaid for the full fiscal year. Cliborn will debit prepaid expenses $100,000 and credit cash the same. At the end of the fiscal year Cliborn will debit rent expense and credit prepaid rent. Both entries will affect the income statement only. The lease information does not affect the balance sheet but details of the lease should be mentioned in the notes section of the yearly financial statement (FASB).