Question

(Lease Capitalization, Bargain-Purchase Option) Baden Corporation entered into a lease agreement for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease in all terms except there is a bargain-purchase option. After the 5-year lease term, the corporation can purchase each copier for \(1,000, when the anticipated fair value is \)2,500.

Jerry Suffolk, the financial vice president, thinks the financial statements must recognize the lease agreement as a capital lease because of the bargain-purchase option. The controller, Diane Buchanan, 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 the machines will most likely not be worth the $1,000 bargain price.

Instructions

Answer the following questions.

(b) Should the controller’s argument be accepted if she does not really know much about copier technology? Would it make a difference if the controller were knowledgeable about the pace of change in copier technology?

Short answer

Answer

If Buchanan has no particular expertise in copier technology, she has no rational case for her suggestion.

Step-by-step solution

Step-by-Step Solution

Step 1: Meaning of Capital Lease

A capital lease is a long-term lease that is neither reversible nor cancelable. In the capital lease, it transfers all the rights that come with the ownership of the assets while payments are still being made to the owner.

Explaining the argument of the controller

Buchanan's advice is illogical if she has no experience with copier technology. If she has the experience, her solution may be reasonable and not just a way to get around recognizing a liability on the balance sheet.