Question

Question: Savannah, Inc. is a company that manufactures and sells a single product. Unit sales for each of the four quarters of 2017 are projected as follows.

Quarter	Units
First	84,000
Second	150,000
Third	550,000
Fourth	120,000
Annual amount	900,000

Savannah incurs variable manufacturing costs of \(0.40 per unit and variable nonmanufacturing costs of \)0.35 per unit. Savannah will incur fixed manufacturing costs of \(720,000 and fixed nonmanufacturing costs of \)1,080,000. Savannah will sell its product for $4.00 per unit.

Accounting

Determine the amount of net income Savannah will report in each of the four quarters of 2017, assuming actual sales are as projected and employing the integral approach to interim financial reporting. (Ignore income taxes.) Repeat the analysis under the discrete approach.

Analysis

Compute Savannah’s profit margin on sales for each of the four quarters of 2017 under both the integral and discrete approaches. Discuss the effects of employing the integral and the discrete approaches on the degree to which Savannah’s profit margin on sales varies from quarter to quarter.

Principles

Explain the conceptual rationale behind the integral approach to interim financial reporting.

Short answer

Answer

1. The present value of minimum lease payments is $8,224.16.
2. The denominator of the return on assets ratio will be understated.
3. Arranging a lease to prevent capitalization detracts from accurate representational reporting of the leasing agreement.

Step-by-step solution

Meaning of Lease

A lease is a contract that transfers land, equipment, or facilities for a specified period and a set rate. The two parties involved in a lease agreement are a lessor and a lessee.

(a) Explaining the Accounting

The four conditions for lease capitalization are:

1. Title transfer
2. Bargain-purchase option
3. Lease term of 75 percent or more of the leased asset's economic life
4. Present value of minimum lease payments of 90 percent 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 shown below.

Calculation of minimum lease payments:

$$\begin{gathered} \text{Minimum} \text{lease}\text{payments}=\text{Rental}\text{payments}-\text{Executory}\text{costs} \\ =\$3,557.25-4500 \\ =\$3,057.25 \end{gathered}$$

Calculation of present value of minimum lease payments:

$$\begin{gathered} \text{Present} \text{value}=\text{Minimum}\text{lease}\text{payments}\times {\text{PVF - AD}}_{\text{3,12}} \\ =\$3,057.25\times 2.69005 \\ =\$8,224.16 \end{gathered}$$

Calculation of present value of minimum lease payments as % of fair value:

$$\begin{gathered} \text{Percentage} \text{fair} \text{value}=\frac{\text{Present} \text{value}}{\text{Fair}\text{vale}} \\ =\frac{\$8,224.16}{\$10,000} \\ =.08224\text{or}82.24\text{percent} \end{gathered}$$

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

Date	Particular	Debit ($)	Credit ($)
	Rent Expense	3,557.25
	Cash		3,557.25

(b) Explaining the Analysis

The leased assets and the liability for the non-cancelable lease payments are "off-balance-sheet" when corporations structure leases to avoid capitalization.

Consequently, the denominator of the return on assets ratio (ROA = Net income Average assets) will be understated, making a company appear more profitable than it is.

Therefore, the ratio of total debt to total assets (Total debt Total assets) will be understated, making it appear like the company is more solvent.

Capitalizing leases differently will be difficult to compare companies based on ROAs and debt to total assets.

(c) Explaining the Principles

The aspect of accurate representation 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 duty constitutes a certain obligation and fulfills the criteria of liability, it should be recognized. Of course, arranging a lease to prevent capitalization detracts from accurate representational reporting of the leasing agreement, which may or may not be neutral.