Case 13-4 Application of SFAC No. 13
On January 1, 2006, Lani Company entered into a non cancelable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Lani by the end of the lease term. The term of the lease is eight years. The minimum lease payment made by Lani on January 1, 2006, was one of eight equal annual payments. At the inception of the lease, the criteria established for classification as a capital lease by the lessee were met.
Required:
a. What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a capital lease.
b. How should Lani account for this lease at its inception and determine the amount to be recorded?
c. What expenses related to this lease will Lani incur during the first year of the lease, and how will they be determined?
d. How should Lani report the lease transaction on its December 31, 2006, balance sheet?
a. The theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee is to ensure that the financial statements of the lessee accurately reflect the economic substance of the lease transaction. This standard, set forth in SFAC No. 13 (Statement of Financial Accounting Concepts No. 13), aims to improve the relevance and reliability of financial reporting by providing guidelines for the recognition, measurement, and presentation of leases.
b. Lani should account for this lease at its inception by recognizing it as a capital lease on its balance sheet. The amount to be recorded would be the present value of the minimum lease payments, discounted at the appropriate interest rate. Lani would debit the leased asset and credit the lease liability for the same amount.
c. During the first year of the lease, Lani will incur expenses related to the lease. These expenses consist of interest expense on the lease liability and depreciation expense on the leased asset. Interest expense is calculated based on the carrying amount of the lease liability multiplied by the interest rate implicit in the lease. Depreciation expense is determined by allocating the cost of the leased asset over its useful life.
d. On its December 31, 2006, balance sheet, Lani should report the lease transaction as a long-term asset and a long-term liability. The leased asset should be reported as Property, Plant, and Equipment, or a separate category if applicable, and the lease liability should be reported as Long-Term Debt or a similar category. The carrying amounts of the leased asset and the lease liability should be adjusted for the interest expense and depreciation expense incurred during the year.