Accounting: What the Numbers Mean 9th Edition by Wayne W McManus, Daniel F Viele, David H Marshall

Exercise 96

Accounting for capital leases On January 1, 2010, Carey, Inc., entered into a noncancellable lease agreement, agreeing to pay $3,500 at the end of each year for four years to acquire a new computer system having a market value of $10,200. The expected useful life of the computer system is also four years, and the computer will be depreciated on a straight-line basis with no salvage value. The interest rate used by the lessor to determine the annual payments was 14%. Under the terms of the lease, Carey, Inc., has an option to purchase the computer for $1 on January 1, 2014.

Required:

a. Explain why Carey, Inc., should account for this lease as a capital lease rather than an operating lease. (Hint: Determine which of the four criteria for capitalizing a lease have been met.)

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b. Show in a horizontal model or write the entry that Carey, Inc., should make on January 1, 2010. Round your answer to the nearest $10. (Hint: First determine the present value of future lease payments using Table 6-5.)

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c. Show in a horizontal model or write the entry that Carey, Inc., should make on December 31, 2010, to record the first annual lease payment of $3,500. Do not round your answers. (Hint: Based on your answer to part b, determine the appropriate amounts for interest and principal.)

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d. What expenses (include amounts) should be recognized for this lease on the income statement for the year ended December 31, 2010?

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e. Explain why the accounting for an asset acquired under a capital lease isn’t really any different than the accounting for an asset that was purchased with money borrowed on a long-term loan.

Step 1 of 8

a) A lease is a capital lease if it has any of the following characteristics:

1. It transfers the ownership of the asset to the lease.

2. The lessee can purchase the asset for a nominal value (bargain purchase) at end of the lease period.

3. The lease period is atleast 75 percent of the economic life of the asset.

4. The present value of the lease payments is atleast 90 percent of the fair value of the asset.