Concept explainers
Case 2. Sherry Talbot, the CEO of Talbot Corporation, was meeting with the company controller to discuss a possible major lease of a new production facility. Talbot Corporation had a large amount of debt, and Sherry was concerned that adding more debt to acquire the production facility would worry the stockholders. Sherry knew that if the production facility could be classified as an operating lease rather than a capital lease, the lease obligation would not have to be reported on the balance sheet. Thus, the company could have a new production facility without having to report any additional debt. The accountant told Sherry that if the title to the production facility transferred automatically to Talbot at the end of the lease term, then the lease would have to be classified as a capital lease. Also, if the lease had a bargain purchase option, such that Talbot Corporation could simply purchase the facility at the end of the lease term for a small amount, it would also be classified as a capital lease. Sherry said not to worry because she would make sure that the lease contract would not contain any title transfer or bargain purchase option. The accountant then said that the facility had a 25-year life and the lease was for 20 years, which was more than 75 percent of the economic life of the asset, so it would have to be classified as a capital lease. Sherry then said she would change the lease term to 18 years, so the lease term would be less than the 75 percent of the economic life of the facility. The accountant then computed the present value of all the lease payments, and the total was more than 90 percent of the market value of the facility. Again, Sherry said she would make any necessary changes so that the total present value of the lease payments would be 89 percent of the current market value of the facility. At this point, the accountant became frustrated and told Sherry that the rules of accounting used to determine the proper classification of a lease were not meant to be used in order to misclassify a leased asset and thereby provide misleading information. Sherry then said the rules simply served as a guide for structuring the lease and that she was merely using the rules to allow the lease to be classified as an operating lease, and thus the lease obligation would not have to be recorded. The accountant said that intentionally avoiding the rules was unethical and wrong.
Requirements
Why does Sherry want to have the lease classified as an operating lease rather than a capital lease?
Does the accountant have a legitimate argument? Does Sherry have a legitimate argument?
What ethical issues are involved?
Do you have any other thoughts?
Want to see the full answer?
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Financial Accounting, Student Value Edition (5th Edition)
- Lewis’s management has been considering moving to a new downtown location, and they are concerned that these plans may come to fruition prior to the equipment lease’s expiration. If the move occurs then Lewis would buy or lease an entirely new set of equipment, so management would like to include a cancelation clause in the lease contract. What effect would such a clause have on the riskiness of the lease from Lewis’s standpoint? From the lessor’s standpoint? If you were the lessor, would you insist on changing any of the other lease terms if a cancelation clause were added? Should the cancelation clause contain provisions similar to call premiums or any restrictive covenants and/or penalties of the type contained in bond indentures? Explain your answer.arrow_forwardSuppose that you have been given a summer job as an intern at Issac Aircams, a company that manufactures sophisticated spy cameras for remote-controlled military reconnaissance aircraft. The company, which is privately owned, has approached a bank for a loan to help finance itsgrowth. The bank requires financial statements before approving the loan.Required:Classify each cost listed below as either a product cost or a period cost for the purpose of preparing financial statements for the bank.1. Depreciation on salespersons’ cars.2. Rent on equipment used in the factory.3. Lubricants used for machine maintenance.4. Salaries of personnel who work in the finished goods warehouse.5. Soap and paper towels used by factory workers at the end of a shift.6. Factory supervisors’ salaries.7. Heat, water, and power consumed in the factory.8. Materials used for boxing products for shipment overseas. (Units are not normally boxed.)9. Advertising costs.10. Workers’ compensation insurance for factory…arrow_forwardA lease is an agreement in which the lessor conveys the right to use an asset for an agreed period of time to the lessee in return for a payment or series of payments (IAS 17.4). Because of rapid changes in technologies, most of the production companies involve in the lease contracts rather than of purchasing new machineries. Being the accounting specialization student, how will you support this? Explain any three advantages of this contract with suitable examples.arrow_forward
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- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning