Cuby Corporation entered into a lease agreement for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease

Cuby Corporation entered into a lease agreement for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease in all ways except that there is a bargain purchase option. After the five-year lease term, the corporation can purchase each copier for $1,000, when the anticipated market value of each machine will be $2,500.

Glenn Beckert, the financial vice-president, thinks the financial statements must recognize the lease agreement as a finance lease because of the bargain purchase clause. The controller, Tareek Koba, 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 copier technology advances rapidly and that by the end of the lease term—five years in the future—the machines will most likely not be worth the $1,000 bargain price.

Instructions

Answer the following questions.

(a) Is there an ethical issue at stake? Explain.

(b) Should the controller’s argument be accepted if she does not really know much about copier technology? Would your answer be different if the controller were knowledgeable about how quickly copier technology changes?

(c) What should Beckert do?

(d) What would be the impact of these arguments on the company’s statement of financial position under the contract-based approach for reporting leases? What impact would Koba’s argument have in this case?

(a) The ethical issues relate to fairness and integrity of financial reporting versus profits and possibly misleading financial statements. On one hand, if Koba can substantiate her position, it is possible that the agreement should be considered an operating lease arguing that this is not a bargain purchase option, in reality, since the value of the photocopiers will likely be below this price. On the other hand, if Koba cannot or will not provide substantiation, she would appear to be trying to manipulate the financial statements for some reason such as a debt covenant or minimum levels of certain ratios.

(b) If Koba has no particular expertise in copier technology, she has no rational case for her suggestion. If she has expertise, then her suggestion may be rational and would not be merely a means to manipulate the statement of financial position to avoid recording a liability. Another explanation may be based on Koba’s past experience, where photocopy manufacturers or lessors have approached Koba before the expiration of past leases to upgrade existing equipment with more modern and cost effective models in order to keep good customer relations. Under those circumstances, Koba would expect that this trend would continue in the future, justifying her position that this is not a bargain purchase option that will be exercised, and to treat the lease as an operating lease.

(c) Beckert must decide whether the situation presents a legitimate difference of opinion where professional judgment could take the answer either way, or as an attempt by Koba to mislead reporting on the financial statements. Beckert must decide whether he wishes to argue with Koba or simply accept Koba’s position. Beckert should assess the consequences of both alternatives.

(d) Under the contract-based approach, the contractual lease obligation will be reported on the statement of financial position regardless of whether a bargain purchase option is seen to exist or not.  The only difference will be how the asset will be recognized.  If the bargain purchase option does not exist, based on Koba’s arguments, then the contractual lease rights are recognized as an intangible asset.  This intangible asset would be amortized on some systematic pattern of usage over the lease term.  If the bargain purchase option is likely to be exercised, then the lease agreement is, in substance, an acquisition, and the copiers would be recorded as equipment.  In this case, the equipment would be depreciated over their useful lives.