ACC 318 Module 3 Lease Accounting Assignment Example

One Building, One Set of Trampolines: Classifying and Measuring Two Leases Under ASC 842

[Student Name]

Southern New Hampshire University

ACC 318: Intermediate Accounting II

Module Three Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

One Building, One Set of Trampolines: Classifying and Measuring Two Leases Under ASC 842

Introduction

In January the trampoline park chain signed two leases. The first is for a former big-box store in suburban Oklahoma City that will become its nineteenth park: a ten-year term, rent of $480,000 due every January 1, no option to buy, and a building with a remaining economic life of about forty years and a fair value of $9.5 million. The second is for the park's main trampoline courts and foam pits: five years, $86,000 paid at the end of each year, with an option to buy the equipment for $1 at the end of the term, and an economic life of about seven years. The company cannot determine the lessors' implicit rates, so it uses its incremental borrowing rate of 6 percent. This assignment classifies each lease under ASC 842, measures the asset and liability, and prepares first-year schedules.

Classification

ASC 842 gives the lessee five questions; a single yes makes the lease a finance lease, and five noes make it an operating lease (Financial Accounting Standards Board, 2016).

Table 1. Classification Tests

The building lease meets none of the tests. The equipment lease meets two: a $1 option is certain to be exercised, and five years is most of the courts' seven-year life. One criterion would have been enough.

Measuring the Building Lease

Rent is due on day one of each lease year, so the stream is an annuity due.

Lease liability = $480,000 x [1 + (1 minus 1.06^-9) / 0.06] = $480,000 x 7.801692 = $3,744,812.

The right-of-use asset is measured at the same amount, since there were no initial direct costs, prepaid rent or incentives. Both the asset and the obligation open at $3,744,812, and the first $480,000 leaves the bank the same day, reducing the liability to $3,264,812.

For an operating lease, ASC 842 requires a single lease cost recognized on a straight-line basis, here $480,000 annually. Underneath that one line, the obligation grows with interest and the asset is reduced by whatever amount keeps the total cost level.

Table 2. Building Lease, First Year

The income statement shows one line, lease cost of $480,000, within operating expenses.

Measuring the Equipment Lease

The equipment payments are made at the end of each year, so they form an ordinary annuity. The $1 purchase price at the end of the term is too small to change the result.

Lease liability = $86,000 x [(1 minus 1.06^-5) / 0.06] = $86,000 x 4.212364 = $362,263.

Since the company will almost surely pay the $1 and keep the courts, the asset is written off across their seven useful years rather than the five-year term, giving straight-line amortization of $51,752 a year.

Table 3. Equipment Lease, First Year

For the finance lease, interest and amortization appear separately: interest expense below operating income and amortization within operating expenses. Because interest is highest when the liability is largest, total finance lease expense is front-loaded, declining each year as the liability falls.

Comparing the Two Patterns

Both leases now sit on the balance sheet, which was the point of ASC 842. Under the old standard the building lease would have been an off-balance-sheet operating lease, with only a footnote describing $4.8 million of future payments. Today the company reports $3.46 million of building lease liability at year end, roughly a third of its total long-term obligations, and its debt-to-equity ratio rises accordingly. Altamuro et al. (2014) found that credit rating agencies already adjusted for operating leases before the new standard, but that their adjustments were imperfect; putting leases on the balance sheet gives every user the same starting point.

The income statements still differ. The operating lease produces level cost and keeps the whole amount in operating expenses, so it does not affect interest coverage ratios. The finance lease produces higher expense in early years and moves part of it into interest. Kieso et al. (2019) note that the dual model was a compromise: the FASB kept the income statement distinction between the two types even after moving both onto the balance sheet. For a chain that will lease many more buildings, the practical lesson is that its balance sheet will carry growing lease liabilities that its bank should be told about before covenants are reset.

The notes add detail a reader needs. ASC 842 requires lessees to disclose the weighted average remaining lease term and discount rate, a maturity analysis of undiscounted lease payments reconciled to the liability, and the components of lease cost. For this company the maturity table would show nine remaining building payments of $480,000 and four equipment payments of $86,000, with the difference between the undiscounted total and the recorded liabilities explained as interest. A lender reading that table can judge how much of the company's future cash is already committed, which was the information most often missing before the standard changed.

Conclusion

The ten-year building lease fails all five classification tests and is an operating lease, measured at $3,744,812 and expensed at a level $480,000 a year. The five-year equipment lease, with a $1 purchase option, is a finance lease measured at $362,263, with first-year expense of $73,488 split between interest and amortization. Both add assets and liabilities to the balance sheet, and the company should plan its covenants with that in mind.

References

Altamuro, J., Johnston, R., Pandit, S., & Zhang, H. (2014). Operating leases and credit assessments. Contemporary Accounting Research, 31(2), 551-580. https://doi.org/10.1111/1911-3846.12033

Financial Accounting Standards Board. (2016). Leases (Topic 842) (Accounting Standards Update No. 2016-02). Author.

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate accounting (17th ed.). Wiley.