Get instant access to this case solution for only $19
Leasing Computers at Persistent Learning Case Solution
Persistent learning deals with educational tools and softwares that aid students in learning. The target market was very large and untapped. Initially, there was no competitor of the company and with sophisticated systems and softwares, the company succeeded in capturing a large market share. At first, company used Venture Capital to finance immense growth of the company. The company went public on NSADAQ and completed its initial public offering in 2004. By spending equity funds on a range of very successful projects at its disposal, company expected enormous expansion in upcoming years. For these new projects, company needed new computers. The company narrowed down the options of obtaining equipment to two types of leases; one-dollar-purchase lease and fair value lease. However, leasing equipment was not a normal practice in this industry; management was concerned about financial reporting implications of different options. The company does not want to create complications in its financial statements at this stage.
Following questions are answered in this case study solution:
How would the company account for the “fair market value” and “one dollar purchase” leases for the computers, over the course of the next three years? Classify the leases as operating or capital lease, and for each year, show journal entries or T-accounts.
Directionally, what are the effects on the balance sheet, income statement, and statement of cash flow?
The company is trying to decide between the “fair-market value” lease and the “one dollar purchase” lease. Which leasing alternative would you choose? Why?
Why do the competitors own their own computers?
Leasing Computers at Persistent Learning Case Analysis
1. How would the company account for the “fair market value” and “one dollar purchase” leases for the computers, over the course of the next three years? Classify the leases as operating or capital lease, and for each year, show journal entries or T-accounts.
Accounting standard for leases has set four criteria’s for classification of leases as operating lease or capital lease. One dollar purchase option lease agreement satisfies two of the conditions given in the standard. First, the present value of lease payments of one-dollar option have a present value greater than 90% of the present fair value of the equipment. Calculation of the present value of lease payments of $2,497,430 for three years at an interest rate of 12% shows that the present value comes out to be $5,998,410. This value is 95% of the present fair value of the equipment ($6,300,000). Therefore, fourth criterion for classification of this lease as “capital lease” has been satisfied. Furthermore, One-dollar lease also gives the option to the company to purchase the equipment at the end of the lease term at a price significantly less than fair value at the end of the lease term. Therefore, One-dollar lease can be classified as a capital lease and should be treated accordingly in the financial statements.
On the other hand, if lease payments of “fair value” approach are discounted on an interest rate of 12%, present value of these lease payments comes out to be $5,276,830. This value is 84% of the fair value of the equipment, and hence, the criterion of present value being more than 90% is not satisfied. Other three conditions given in accounting standard for lease are also not satisfied by this lease. Hence, fair value lease should be classified as operating lease.
So, if the company opts for “fair value” method of the lease, then lease payments should be treated as an expense since this is an operating lease. The equipment will not be recognized on the balance sheet of the company because leases do not bear significant risks of the equipment. Therefore, journal entries for this type of lease will be simple rental expense against cash each year.
For “one-dollar” lease, initially, leased asset will be recognized in the balance sheet at the present value of the lease payments. This present value will be depreciated on a straight line basis over three years of the lease period. Present value of lease payments at discount rate of 12% comes out to be $5,998,410. Dividing this value by 3, depreciation expense of $1,999,470 can be obtained. The credit entry of annual cash lease payments will be recorded against debt entries of interest expense and capital lease liability. The balance of the lease liability will decrease every year by the amount of this debt entry of the lease liability. Interest expense will be calculated as 12% of the net capital lease liability value left on the balance sheet. Detailed journal entries for next three years of the lease term can be found in “journal entries” tab of the excel sheet.
2. Directionally, what are the effects on the balance sheet, income statement, and statement of cash flow?
The effects of both types of leases are very different based on their accounting treatment. Since, fair value lease is an operating lease, annual lease payments in this case are recorded as rental expenses. If, effects of this lease on the income statement are compared with those if the company had purchased the equipment by borrowing funds, expenses are much greater for operating lease. Operating expenses of the company will increase by lease payments of $2,197,004 and decrease by depreciation expense of $1,575,000 for purchased equipment. This leads to a net increase in operating expenses by $622,004. Hence, assuming this operating lease is chosen by the company, projected income statement for 2007 shows a net loss of $69,000. If, operating lease is chosen instead of purchasing, then assets and liabilities of the company will decrease by the amount of Net Value of equipment and long term debt of $6.3 million. Deficit of the company will decrease and hence; overall value of the company will be less for 2007. As far as cash flow is concerned, it will also show a negative figure because of a large loss in the income statement. As compared to a positive value of net cash flow of $107,000 for purchase method, a negative net cash flow of $1,881,040 appears for 2007.
Since one-dollar lease is a capital lease, it will be capitalized and depreciated every year. Just like operating lease, capital lease will also decrease net income of 2007. Depreciation expense will increase by $1,999,470 and decrease by $1,575,000. This will lead to a net increase in depreciation expense of $424,470. Instead of a net income of $175,000 for purchase method, capital lease method shows a value of $17.23 for 2007. In the balance sheet, present value of the lease payments will be recorded as leased asset while liability side will show this amount as lease liability. Projected cash flow for this method for year 2007 becomes negative because of huge lease payments. As compared to net cash value of $107,000 for purchase method, capital lease method will give a net cash flow of $204,700.
Hence, both types of leases will make the profitability and liquidity position of the company look very bad at least for 2007.
3. The company is trying to decide between the “fair-market value” lease and the “one dollar purchase” lease. Which leasing alternative would you choose? Why?
The company should choose “one-dollar” lease over “the fair value” lease due to a better impact of former on financial statement of the company for 2007. Since, venture capitalists and other large shareholders of the company are selling their shares; it is a very crucial time for the company to sustain its reputation.
Get instant access to this case solution for only $19
Get Instant Access to This Case Solution for Only $19
Save $6 on your purchase
Different Requirements? Order a Custom Solution
Calculate the Price
Get More Out of This
Our essay writing services are the best in the world. If you are in search of a professional essay writer, place your order on our website.