Lease Amortization Schedule

Effective Decrease Outstanding Payments Interest in Balance Balance 2% x Outstanding Balance

40,000,000

2,398,303 2,398,303 37,601,697

2,398,303 .02 (37,601,697) = 752,034 1,646,269 35,955,428

2,398,303 .02 (35,955,428) = 719,109 1,679,194 34,276,234

2,398,303 .02 (34,276,234) = 685,525 1,712,778 32,563,456

2,398,303 .02 (32,563,456) = 651,269 1,747,034 30,816,422

2,398,303 .02 (30,816,422) = 616,328 1,781,975 29,034,448

2,398,303 .02 (29,034,448) = 580,689 1,817,614 27,216,835

2,398,303 .02 (27,216,835) = 544,337 1,853,966 25,362,869

2,398,303 .02 (25,362,869) = 507,257 1,891,046 23,471,823

2,398,303 .02 (23,471,823) = 469,436 1,928,867 21,542,957

2,398,303 .02 (21,542,957) = 430,859 1,967,444 19,575,514

2,398,303 .02 (19,575,514) = 391,510 2,006,793 17,568,722

2,398,303 .02 (17,568,722) = 351,374 2,046,929 15,521,794

2,398,303 .02 (15,521,794) = 310,436 2,087,867 13,433,927

2,398,303 .02 (13,433,927) = 268,679 2,129,624 11,304,303

2,398,303 .02 (11,304,303) = 226,086 2,172,217 9,132,086

2,398,303 .02 (9,132,086) = 182,642 2,215,661 6,916,425

2,398,303 .02 (6,916,425) = 138,328 2,259,975 4,656,450

2,398,303 .02 (4,656,450) = 93,129 2,305,174 2,351,276

2,398,303 .02 (2,351,276) = 47,027* 2,351,276 0

* rounded

Case 15-2 (concluded)

Requirement 2

After the first full year under the warehouse lease, the carrying amount (after accumulated depreciation) of Dowell’s leased warehouses is 32,000,000:

$40,000,000 Leased warehouses, PV of lease payments

÷ 5 years Life of lease

$ 8,000,000 Accumulated depreciation after one year

$40,000,000 Leased warehouses, PV of lease payments

(8,000,000) Accumulated depreciation after one year

$32,000,000 Carrying amount after one year

Requirement 3

The specific citation that specifies the guidelines for derecognition of capital leases is FASB ACS 840–30–40: “Leases–Capital Leases–Derecognition.” Accounting for lessees is described in paragraph 40–1 and 2; “Lease Modifications.”

(a) if the proposal to sublease will qualify as a termination of a capital lease:

840–10–40–2: "Leases–Overall–Derecognition–Lessees"

If the nature of a sublease is such that the original lessee is relieved of the primary obligation under the original lease, the transaction should be considered a termination of the original lease agreement.

(b) the appropriate accounting treatment for the sublease:

Because Dowell’s proposed sublease is a termination of a capital lease before the expiration of the lease term, it falls under Par. 40–1:

40–1 A termination of a capital lease before the expiration of the lease term is accounted for by the lessee by removing the asset and obligation, with gain or loss recognized for the difference.

Requirement 4

In accordance with FASB ACS 840–30–40–1, the asset and obligation representing the original lease would be removed from the accounts and a loss would be recognized for the difference. The journal entry Dowell would record in connection with the sublease is:

Lease payable (balance after 4 quarters; from req. 1) 30,816,422

Loss on sublease (to balance) 1,183,578 Accumulated depreciation (balance: from req. 2) 8,000,000

Leased warehouses(balance: PV of lease payments) 40,000,000

Communication Case 15-3

First, this case has no single right answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole.

It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Discussion likely will include the following:

a. Possible advantages of leasing include:

1. Leasing can preserve the ability to borrow under lines of credit.

2. Leasing can provide an interest rate lower than the incremental borrowing rate.

3. Leasing may avoid violating restrictive loan agreements that prohibit the issuance of additional debt securities.

4. Leasing can lessen the risk of obsolescence.

5. Leasing allows 100% financing at fixed interest rates as compared with 70% to 90% financing when assets are purchased.

b. The lessee views a noncancelable lease as a capital lease if it meets at least one of the following criteria.

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

2. The lease contains a bargain purchase option.

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

4. The present value of the minimum lease payments, excluding executory costs, equals or exceeds 90% of the fair value of the leased property.

1. and 3. are not met. 2. and 4. are met – if the purchase option is viewed as a bargain purchase option. Is $290,000 enough less than $300,000 that exercise of the option is expected to occur? If so:

2. The right to purchase the vans at the end of the lease term for $290,000, when the estimated fair value is $300,000, is a bargain purchase option.

4. The present value of the minimum lease payments, not including the executory costs, is greater than 90% of the fair value of the vans, calculated as follows:

Case 15-3 (continued)

Present value of minimum lease payments, assuming a BPO:

Lease payments ($300,000 x 3.48685) $1,046,055

Bargain purchase price ($290,000 x 0.68301) 198,073

Total $1,244,128

In this case, it is a capital lease.

Otherwise:

Present value of minimum lease payments, assuming the purchase option is not a BPO:

Lease payments ($300,000 x 3.48685) $1,046,055

Fair value of vans $1,240,000

x 90%

90% of the fair value of the vans $1,116,000

In this case, it is an operating lease to the lessee.

Either way, it is a capital lease to the lessor:

Present value of minimum lease payments, assuming a BPO:

Lease payments ($300,000 x 3.48685) $1,046,055

Bargain purchase price ($290,000 x 0.68301) 198,073

Total $1,244,128

Present value of minimum lease payments, assuming the purchase option is not a BPO:

Lease payments ($300,000 x 3.48685) $1,046,055

Residual value ($300,000 x 0.68301) 204,903

Total $1,250,958

Since Interstate’s cost, $1,050,000, was less than its “selling price,” this is a sales-type lease to Interstate.

Case 15-3 (concluded)

c. VIP would record the following at December 31, 2011:

Interest expense ([$1,100,000 – 300,000] x 10%)80,000Lease liability 220,000 Cash 300,000

Operating expenses 1,000

Cash 1,000

If a BPO is assumed, VIP would have the vans for 7 years:

Depreciation expense ([$1,100,000 – 50,000] ÷ 7 yrs.) 150,000

Accumulated depreciation 150,000

If a BPO is not assumed, VIP would have the vans for 4 years:

Depreciation expense ([$1,100,000 – 300,000] ÷ 4 yrs.) 200,000

Accumulated depreciation 200,000

Ethics Case 15-4

Discussion should include these elements:

Leasehold improvement depreciation period

There may be some degree of latitude associated with uncertainty concerning the life of the leasehold improvements. However, trade publications indicate 25 years probably is out of range. The suggestion to use 25 years clearly is motivated by the desire to “window dress” performance.

Ethical Dilemma:

How does a doubtful justification for the estimated life of leasehold improvements compare with the perceived need to increase reported profits?

Who is affected?:

Person

Keene

Other managers

Shareholders

Potential shareholders

Employees

Creditors

The company’s auditors