Interior Design Inc. (ID) is a privately owned business that produces interior decorating options for consumers. ID has chosen to follow private enterprise GAAP. The software that it purchased 10 years ago to present clients with designs that are unique to their offices is no longer state-of-the-art, and ID is faced with making a decision on the replacement of its software. The company has two options:
1. Enter into a lease agreement with Precision Inc. whereby ID makes an upfront lease payment of $12,000 on January 1, 2012, and annual payments of $4,500 over the next five years on each December 31. At the end of the lease, ID has the option to buy the software for $5,000. The first annual lease payment is on December 31, 2012.
2. Enter into a lease agreement with Graphic Design Inc. on January 1, 2012, whereby ID makes five annual lease payments of $6,500, beginning on January 1, 2012. ID may purchase the software at the end of the lease period for $200.
This is considered a bargain price compared with the offer of $5,000 in the proposal from Precision Inc. Under both options, the software will require annual upgrades that are expected to cost $1,500 per year. These upgrade costs are in addition to the lease payments that are required under the two independent options. As this additional cost is
the same under both options, ID has decided to ignore it in making its choice. The Precision agreement requires a licensing fee of $1,000 to be renewed annually. If ID decides on the Precision option, the licensing fee will be included in the annual lease payment of $4,500. Both Precision Inc. and Graphic Design Inc. offer software programs of similar quality and ease in use, and both provide adequate support. The software under each offer is expected to be used for up to eight years, although this depends to some extent on technological advances in future years. Both offers are equivalent in terms of the product and service.
It is now early October 2011, and ID hopes to have the software in place by its fiscal year end of December 31, 2011.
ID is currently working on preparing its third-quarter financial statements, which its bank is particularly interested in seeing in order to ensure that ID is respecting its debt-to-equity ratio covenant in its loan agreement with the bank. The interest rate on the bank loan, which is ID’s only source of external financing, is 10% per year. ID would have preferred to be in a position where it could buy rather than lease the software, but the anticipated purchase price of $30,000 exceeds the limits that the bank set for ID’s borrowing.
Instructions
(a) Discuss the nature of the lease arrangement under each of the two lease options offered to Interior Design and the corresponding accounting treatment that should be applied.
(b) Prepare all necessary journal entries and adjusting journal entries for Interior Design under the Precision Inc. option, from lease inception on January 1, 2012, through to December 31, 2012.
(c) Prepare an amortization schedule using a computer spreadsheet that would be suitable for the lease term in the Graphic Design Inc. option.
(d) Prepare all necessary journal entries and adjusting journal entries for Interior Design under Graphic Design’s option, from lease inception on January 1, 2012, through to January 1, 2013.
(e) Summarize and contrast the effects on Interior Design’s financial statements for the year ending December 31, 2012, using the entries prepared in parts (b) and (d) above. Include in your summary the total cash outflows that would be made by Interior Design during 2012 under each option.
(f) Discuss the qualitative considerations that should enter into Interior Design’s decision on which lease to sign. Which lease do you think will most likely be chosen by Interior Design? Why?
(g) What are the long-term and short-term implications of the choice between these two options? How do these implications support the direction in which GAAP is headed in the future concerning the accounting for leases?
(a) Option No. 1 - Precision Inc.
Calculation of present value of minimum lease payments: The $5,000 option to buy the software at the end of the lease of five years is not considered a bargain purchase option in view of the $200 price offered by Graphic Design Inc. in Option No. 2.
The lease payments are in the amount of $3,500 as the $1,000 annual licensing fee is an executory cost.
$3,500 X 3.79079* = $13,268
*Present value of an ordinary annuity of 1 for 5 periods at 10%.
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $13,268 |
| I | 10% | |
| N | 5 | |
| PMT | $ (3,500) | |
| FV | $ 0 | |
| Type | 0 | |
Total lease payments:
At inception of lease – January 1, 2011 $12,000
Present value of minimum lease payments 13,268
Total $25,268
This is an operating lease to Interior Design Inc. since the lease term (5 years) is less than 75% of the economic life (8 years) of the leased asset. The lease term is 62.5% (5 ÷ 8) of the asset’s economic life. There is no bargain purchase option and the present value of minimum lease payments of $25,268 represent 84% of the fair value at January 1, 2011 of $30,000 falling short of the criteria of 90% to treat the lease as a capital lease under PE GAAP.
(a) Option No. 2 – Graphic Design Inc.
Calculation of present value of minimum lease payments:
The minimum lease payments in the case include the bargain purchase option of $200. The present value therefore is:
PV of monthly payment *..................... $27,104
PV of bargain purchase option of $200 **.... 124
Present value of minimum lease payments..... $27,228
* Present value of an annuity due of 1 for 5 periods at 10%.
$6,500 X 4.16986 = $27,104
** Present value of a single payment of 1 for 5 periods at 10%
$200 X .62092 = $124
| Excel formula =PV(rate,nper,pmt,fv,type) |
| Using a financial calculator: | ||
| PV | $ ? | Yields $27,228 |
| I | 10% | |
| N | 5 | |
| PMT | $ (6,500) | |
| FV | $ (200) | |
| Type | 1 | |
To Interior Design Inc., this lease is a capital lease because the terms satisfy the following criteria:
1. Although as in Option No. 1, the lease term is not greater than 75% of the economic life of the leased asset; that is, the lease term is 62.5% (5/8) of the economic life, there is a bargain purchase option.
2. The present value of the minimum lease payments is greater than 90% of the fair value of the leased asset; that is, the present value of $27,228 is 91% of the fair value of the leased asset of $30,000: ($27,228 / $30,000 = 90.76%)
(b)
January 1, 2012
Prepaid Software Rental Expense..... 12,000
Cash........................... 12,000
The first payment will be amortized straight-line over the term of the lease.
December 31, 2012
Software Rental Expense............. 3,500
Software License Expense............ 1,000
Cash........................... 4,500
December 31, 2012
Software Rental Expense............. 2,400
Prepaid Software Rental Expense. 2,400
($12,000 / 5 = $2,400)
(c)
Interior Design Inc.
Lease Amortization Schedule with Graphic Design Inc.
| Date | | Annual Lease Payment | | Interest (10%) on Unpaid Obligation | | Reduction of Lease Obligation | | Balance of Lease Obligation |
| | | | | | | | | |
| 1/1/12 1/1/12 1/1/13 1/1/14 1/1/15 1/1/16 1/1/16 | | $6,500 6,500 6,500 6,500 6,500 200 $32,700 | | *$2,073 * 1,630 * 1,143 605607 18 *$5,471 | | $6,500 4,427 4,870 5,357 5,893 182 $27,229 | | $27,228 20,728 16,301 11,431 6,074 181 0 |
(d)
January 1, 2012
Leased Software..................... 27,228
Lease Obligation................ 27,228
January 1, 2012
Lease Obligation.................... 6,500
Cash............................ 6,500
December 31, 2012
Interest Expense................. 2,073
Interest Payable........ 2,073
December 31, 2012
Depreciation Expense................ 3,404
Accumulated Depreciation—Leased
Software...................... 3,404
($27,228 ÷ 8 years = $3,404)
Use 8 years, as option to purchase will be exercised as it is a bargain price.
January 1, 2013
Interest Payable................. 2,073
Lease Obligation................. 4,427
Cash.................... 6,500
(e)
| | Option No. 1 | | Option No. 2 |
| | Operating | | Capital |
| Income statement effects: | Lease | | Lease |
| Rent expense | $3,500 | | |
| Software licensing expense | 1,000 | | |
| | | | |
| Interest expense | | | $2,073 |
| Depreciation expense | _____ | | 3,404 |
| Total expenses | $4,500 | | $5,477 |
| | | | |
Asset and liability balances Dec. 31, 2012
| Current assets: | | | |
| Prepaid software rental | $9,600 | | |
| | | | |
| Non-current assets: | | | |
| Software under capital lease | | | $27,228 |
| Less: accumulated depreciation | | | (3,404) |
| | | | $23,824 |
| | | | |
| Current liabilities: | | | |
| Interest payable | | | 2,073 |
| Current portion of lease obligation | | 4,427 | |
| | | | |
| Non-current liabilities: | | | |
| Lease obligation | | | 20,728 |
| Less current portion | | | (4,427) |
| | | | 16,301 |
| Total liabilities: | | | $22,801 |
| | | | |
| Total cash outflows during 2012 | ($16,500) | | ($6,500) |
(f) Among Interior’s paramount concerns will be ensuring that it continues to meet its debt to equity covenant. Since all financing is done with the bank, Interior Design Inc. may be perceived to be of high risk by the bank. Entering into the Precision Inc. lease (Option No. 1) would provide off balance sheet financing keeping the lease obligation off the balance sheet. Equity would be reduced by the lease payments expensed each period.
In contrast the Graphic Design Inc. (Option No. 2) lease would increase Interior’s liabilities by the present value of the minimum lease payments. Interest expense each period and depreciation of the leased asset will decrease net income and therefore equity each period.
To maintain their debt to equity covenant, Interior would probably choose to enter into the Precision lease (operating lease Option No. 1) to minimize debt on their balance sheet.
(g) In the long term, Option No. 2 presents the better option. The software will be owned and used by Interior over the eight-year useful life of the asset, instead of the five-year term of lease under the operating lease, Option No. 1. The other immediate disadvantage to the operating lease option No. 1 is the large immediate (January 1, 2011) cash outflow required by the prepayment clause under the operating lease of $12,000. This payment could create an important liquidity problem over the term of the lease, especially in the first year.
The conclusion to be drawn from this study is that choices are often made by businesses for reasons outside what makes economic sense overall. The FASB and IASB movement towards removing the distinction between operating and capital leases will eliminate this problem as choices between leases will not be made based on the objective to reduce or eliminate the presence of liabilities on the balance sheet.
The two alternatives are not, strictly speaking, comparable in a capital budgeting sense as the difference in the purchase option leaves option 1 with a 5 year life and option 2 with an 8 year life. The present value of the purchase option in Option 1 (although a non-GAAP treatment) is needed to make the two options comparable (PV is $3,100). Option 2 is therefore superior in a present value sense. It is important to add in any discussion that comparing the accounting treatment without the full picture of the cash flows in arriving at management’s decision is inadequate.
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