Question

Salaur Company is evaluating a lease arrangement being offered by TSP Company for use of a computer system. The lease is noncancelable, and in no case does Salaur receive title to the computers during or at the end of the lease term. The lease starts on January 1, 2017, with the first rental payment due on January 1, 2017. Additional information related to the lease is as follows.

Yearly rental	\(3,557.25
Lease term	3 years
Estimated economic life	5 years
Purchase option	\)3,000 at end of 3 years, which approximates fair value
Renewal option	1 year at \(1,500; no penalty for nonrenewal; standard renewal clause
Fair value at inception of lease	\)10,000
Cost of asset to lessor	\(10,000
Residual value:
Guaranteed	–0–
Unguaranteed	\)3,000
Lessor’s implicit rate (known by the lessee)	12%
Executory costs paid by:	Lessor; estimated to be \(500 per year (included in rental equipment)
Estimated fair value at end of lease	\)3,000

Accounting

Analyze the lease capitalization criteria for this lease for Salaur Company. Prepare the journal entry for Salaur on January 1, 2017.

Analysis

Briefly discuss the impact of the accounting for this lease for two common ratios: return on assets and debt to total assets.

Principles

What element of faithful representation (completeness, neutrality, free from error) is being addressed when a company like Salaur evaluates lease capitalization criteria?

Short answer

Minimum lease payments = $3,057.25

Present value of min. lease payments =$8224.16

Step-by-step solution

Meaning of Account Analysis

Account analysis is delving into the specific line items that make up a certain account. Account analysis is very popular for accounts on the balance sheet, as they are real accounts that have consistent amounts from year to year.

Explaining the Accounting of the Salaur Company

There are four conditions for capitalizing a lease. They are:

1. title transfer,
2. bargain-purchase option,
3. lease term of 75% or more of the leased asset's economic life, and
4. Present value of minimum lease payments of 90% or more of the leased asset's fair value.

This lease does not convey ownership. The option to buy at the conclusion of the lease is obviously not a good deal. Because the lease period is (3 5) = 0.6, or 60% of the economic life, the economic life requirement is not satisfied. The investment recovery test is as follows:

Calculation of minimum lease payment

$$\begin{gathered} \text{Minimum}\text{lease}\text{payments}=\text{Rental}\text{payments}-\text{Executory costs} \\ =\$3,557.25-\$500 \\ =\$3,057.25 \end{gathered}$$

Calculation of Present value of min. lease payments

$$\begin{gathered} \text{Present}\text{value}\text{ofminimum}\text{lease}\text{payments}=\text{Rental}\text{payments}\times \text{(PVF - AD)} \\ =\$3,057.25\times 2.69005 \\ =\$8,224.16 \end{gathered}$$

Calculation of present value of minimum lease paymentsas % of fair value

$$\begin{gathered} \text{Present}\text{value}\text{of}\text{min}\text{lease}\text{payments}\text{=}\frac{\text{Present}\text{value}\text{of}\text{lease}}{\text{Fair}\text{value}\text{atinception}\text{of}\text{laese}} \\ =\frac{\$8,224.16}{\$10,000} \\ =0.8224\text{or}82.24\% \end{gathered}$$

As a result, the investment recovery criteria are also not fulfilled. As a result, this lease is classified as an operational lease. As a result, Salaur's journal entry for January 1, 2017, is:

Date	Particular	Debit ($)	Credit ($)
Jan. 1, 2017	Rent Expense	3,557.25
	Cash		3,557.25

Explaining the Analysis of the Salaur Company

Both the rented assets and the risk for the non-cancelable rent payments are "off-balance-sheet" when organizations structure leases to dodge capitalization. As a result, the denominator of the return on assets proportion (ROA = Net income / Average assets) will be overstated, making a firm appear to be more productive than it is.

The debt-to-total-assets ratio (Total debt/Total assets) will be overstated, providing the appearance that the organization is more solvent than it is. It will be impossible to compare firms based on ROAs and debt to total asset ratios if they capitalizeon different portions of their leases.

Explaining the Principle of the Salaur Company

The aspect of faithful portrayal is a vital feature. The lease criteria are intended to classify leases based on their economic value. Thus, if a corporation controls the risks and benefits of a leased item through a lease agreement, the asset fulfills the definition of an asset and should be recorded on the balance sheet.

Similarly, if the linked liability constitutes an inescapable duty and so fulfills the criteria of liability, it should be acknowledged. That example, if the financial accounts disclose all of the company's assets and liabilities, they faithfully depict (completeness). Of course, arranging a lease to prevent capitalization detracts from the leasing arrangement's representational truthful reporting, which may or may not be neutral.