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.
