Accounting for leases
Paper details:
See attached pdf and excel file for assignment information
Chapter 21
Accounting in Action: GM2
Earlier, Conner and Martin asked you to analyze four proposals for acquiring a
very expensive, very large piece of equipment (refer to Accounting in Action,
Chapter 10). None of the proposals they asked you to review involved leasing the
new equipment. In light of concerns expressed about the potentially short period
of time before new technology makes a machine obsolete, you are surprised that
leasing was not considered. From what you remember, leasing provides some
real benefits. Recall that the fair value of the new equipment is approximately
$685,000 and is expected to have an economic life of eight years.
When the possibility of leasing equipment is discussed, both Conner and
Martin express much interest. They have had prior business dealings with Tyler
Leasing Company, and the results have been satisfactory. You call BuzzTyler
and ask him about leasing the new equipment; the next day, he sends you the
following proposal:
Tyler Leasing Company would acquire the equipment and lease it to CMZ. The
lease payments would be $145,661 for five years, paid at the beginning ofeach
period. CMz would guarantee the residual value of$125,000 at the end ofthe
lease period. The fair market value ofsinllar equipment is $685,000.
The implicit interest rate in this offer is 10%, which is also CM2’s borrowing rate.
Conner and Martin like the proposal and want to know more about the
benefits of leasing versus owning. Remember that their focus is to go to the bond
or equity market at the end of 2013. They do not want to guarantee the residual
Continuing Case 8
value. They are also excited about the possibility of reporting only the rental
expense on the income statement. In addition, they understand that they may not
have to report a liability on the balance sheet, which makes them even happier.
lnstructions
(a) V Analyze the Tyler Leasing Company proposal. Show Conner and
Martin (and also Lopez and Knepp, since they appear to be slightly
skeptical of this idea) the effect ofthe proposal on the company’s balance
sheet. Explain to the four the effect on the relationship between debt and
equity at the present time.
(b) Access file 4a on the website GXeel_Ejlg for information about the
company’s current debt and equity positions. Explain the debt and equity
relationships assuming the leasing proposal results in an operating lease
versus a capital lease. For illustrative purposes, ignore income taxes. Also
help Conner and Martin understand why Tyler wants CM2 to guarantee the
residual amount.
Additional Activities: Ertend vour accountinq knowledqe
V Assuming the leasing atternative is setected, and given your analysis,
Conner and Martin are concemed about the residual value guarantee, given the
changing technology in this market. They indicate they will agree to this lease
only if they do not have to guarantee the residual value.
They place a conference call with Buzz Tyler. He expresses his
company’s concern that they stand to lose a considerable amount if the
Continurng Case 9
