Exam Review for 2008

Exam Review for 2008 - Quick Review of Later Material...

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Unformatted text preview: Quick Review of Later Material Leases There are two different methods which may be used to account for a lease. The choice between them depends on the features of the lease contract: 1) Capital Lease method-- the lease is accounted for as a purchase (sale)-financing transaction. 2) Operating Lease method-- the lease is accounted for as an executory contract. (i.e. as a rental contract which imposes no reportable liability on the firm until the "rented" assets are used). Criteria for a Capital Lease • If the lease is non-cancelable and any one of the following criteria are met, a lease is accounted for as a capital lease : 1) Ownership of the asset (land, buildings and/or equipment) is transferred to the lessee at the end of the lease term. 2) A "bargain purchase" option exists. A bargain purchase option exists if the lessee can purchase the asset for a price that seems sufficiently less than the estimated fair market value on the exercise date that the option is likely to be exercised. 3) The lease term is equal to or greater than 75% of the estimated useful life of the asset. 4) At the inception of the lease (e.g., signing date), the present value of the minimum lease payments is equal to or greater than 90% of the estimated fair market value of the equipment. If none of these four criteria are met, the lease is treated as an operating lease . Accounting for Jerry of the Grateful Dead's Capital Lease Annual Payment 5000 Lease Life 4 years Asset Useful Life 4 Discount rate 0.11 1 2 3 4 Nominal Lease Payments 5000 5000 5000 5000 PV of Lease Payments 4505 4058 3656 3294 PV 15512 LIABILITY Lease Interest Cash Reduction Amount to Start Liability Expense Payment in Liability End be paid off next year Yr1 15512 1706 5000 3294 12219 3656 Yr 2 12219 1344 5000 3656 8563 4058 Yr 3 8563 942 5000 4058 4505 4505 Yr 4 4505 495 5000 4505 ASSET Start Asset Amort. End Yr1 15512 3878 11634 Yr 2 11634 3878 7756 Yr 3 7756 3878 3878 Yr 4 3878 3878 Why might the lessee prefer to account for a lease as an operating lease (rather than as a capital lease)? a) Operating lease accounting has a less adverse impact on the book leverage (debt/equity) ratio. When the lease is accounted for as an operating lease, no liability is ever recorded. On the other hand, accounting for the lease as a capital lease requires that a liability be recorded when the contract is signed. b) Although total expenses recognized are the same over the life of the lease , the expense in the early years are typically less for an operating lease than for a capital lease. Operating Lease (Expenses) Capital Lease (Expenses) [Lease Payment] [Amortization + Interest] Year 1 5000 3,878 + 1,706 = 5,584 Year 2 5000 3,878 + 1,344 = 5,222 Year 3 5000 3,878 + 942 = 4,820 Year 4 5000 3,878 + 496 = 4,374 20000 20000 Stock Dividends • Note, that as a result of a stock dividend, the balance of the Retained Earnings account is reduced just as in the case of a cash dividend . However, in the case of a cash dividend the shareholders' are receiving something of value (and the real...
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This note was uploaded on 02/21/2009 for the course ACCT 102 taught by Professor Defoe during the Spring '08 term at UPenn.

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Exam Review for 2008 - Quick Review of Later Material...

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