Question

Baden Corporation entered into a lease agreement for 100 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease except there is a bargain purchase option. After the 5-year lease term, the corporation can purchase each copier for $1,000, when the anticipated fair value is $2,500. Jerry Suffolk, the financial vice president, thinks the financial statements must recognize the lease agreement as a finance lease because of the bargain purchase option. The controller, Diane Buchanan, disagrees: “Although I don’t know much about the copiers themselves, there is a way to avoid recording the lease liability.” She argues that the corporation might claim that the copier technology advances rapidly and that by the end of the lease term, the machines will most likely not be worth the $1,000 bargain price.

(a) What ethical issue is at stake?

(b) Should the controller’s argument be accepted if she does not really know much about copier technology? Would it make a difference if the controller were knowledgeable about the rate of change in copier technology?

(c) What should Suffolk do?

Answer 1

a) The ethical issue at stake is to whether record the lease as financial or operating, because there is no need to record operating lease as asset or liability in financial statements. But Financial lease is recorded as both an asset and a liability on the financial statements, generally at the present value of the rental payments (but never greater than the asset's fair market valueStatement of Financial Accounting Standards No. 13 (FAS 13). But as bargain purchase option is mentioned in the lease so lease is said to be a financial lease.

b) No without knowing the facts and calculating the actual residual value the argument of controller should not be entertained.

Yes, if the controller were knowledgeable about the rate of change in copier technology then the actual fair value could have been calculated on this basis.

c) Sufflok should represent lease as financial lease only, but he can get the terms of lease revised as to the fair value of copier revised after the proper analysis and computation of copier value , so as to revise bargain price as $1000 or less.