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.
