Apply your critical-thinking ability to the knowledge you’ve gained. These cases will provide you an oppor- tunity to develop your research, analysis, judgment, and communication skills. You also will work with other students, integrate what you’ve learned, apply it in real world situations, and consider its global and ethical ramifications. This practice will broaden your knowledge and further develop your decision-making abilities. Refer to the most recent financial statements and related disclosure notes of Walmart Stores, Inc. You can find these at the Walmart website, walmartstores.com , or by using Edgar at www.sec.gov . Management’s Dis- cussion and Analysis states that Walmart has $12,830,000,000 of “Unrecorded Contractual Obligations: Non- cancelable operating leases.”
Required:
1. What does Walmart’s management mean when it says “Unrecorded Contractual Obligations” in this context? 2. See the note on “Commitments” in the disclosure notes. What is Walmart’s capital lease liability?
Analysis Case 15–1 Reporting leases; operating leases; Walmart ● LO1 through LO5
3. If the operating leases were capitalized, approximately how much would that increase the capital lease liability?
4. What effect would that have on the company’s debt-equity ratio? (Refer to the balance sheet.)
“I don’t see that in my intermediate accounting text I saved from college,” you explain to another member of the accounting division of Dowell Chemical Corporation. “This will take some research.” Your comments pertain to the appropriate accounting treatment of a proposed sublease of warehouses Dowell has used for product storage.
Dowell leased the warehouses one year ago on December 31. The five-year lease agreement called for Dowell to make quarterly lease payments of $2,398,303, payable each December 31, March 31, June 30, and September 30, with the first payment at the lease’s inception. As a capital lease, Dowell had recorded the leased asset and liability at $40 million, the present value of the lease payments at 8%. Dowell records depreciation on a straight-line basis at the end of each fiscal year.
Today, Jason True, Dowell’s controller, explained a proposal to sublease the underused warehouses to Ameri- can Tankers, Inc. for the remaining four years of the lease term. American Tankers would be substituted as lessee under the original lease agreement. As the new lessee, it would become the primary obligor under the agreement, and Dowell would not be secondarily liable for fulfilling the obligations under the lease agreement. “Check on how we would need to account for this and get back to me,” he had said.
Required:
1. After the first full year under the warehouse lease, what is the balance in Dowell’s lease liability? An amortization schedule will be helpful in determining this amount.
2. After the first full year under the warehouse lease, what is the carrying amount (after accumulated depreciation) of Dowell’s leased warehouses?
3. Obtain the relevant authoritative literature on accounting for derecognition of capital leases by lessees using the FASB’s Codification Research System. You might gain access from the FASB website ( www.fasb.org ), from your school library, or some other source. Determine the appropriate accounting treatment for the proposed sublease. What is the specific Codification citation that Dowell would rely on to determine: a. if the proposal to sublease will qualify as a termination of a capital lease, and
b. the appropriate accounting treatment for the sublease?
4. What, if any, journal entry would Dowell record in connection with the sublease?
Interstate Automobiles Corporation leased 40 vans to VIP Transport under a four-year noncancelable lease on January 1, 2011. Information concerning the lease and the vans follows:
a. Equal annual lease payments of $300,000 are due on January 1, 2011, and thereafter on December 31 each year. The first payment was made January 1, 2011. Interstate’s implicit interest rate is 10% and known by VIP.
b. VIP has the option to purchase all of the vans at the end of the lease for a total of $290,000. The vans’ estimated residual value is $300,000 at the end of the lease term and $50,000 at the end of 7 years, the estimated life of each van.
c. VIP estimates the fair value of the vans to be $1,240,000. Interstate’s cost was $1,050,000. d. VIP’s incremental borrowing rate is 11%.
e. VIP will pay the executory costs (maintenance, insurance, and other fees not included in the annual lease payments) of $1,000 per year. The depreciation method is straight-line.
f. The collectibility of the lease payments is reasonably predictable, and there are no important cost uncertainties.
Your instructor will divide the class into two to six groups depending on the size of the class. The mission of your group is to assess the proper recording and reporting of the lease described.
Required:
1. Each group member should deliberate the situation independently and draft a tentative argument prior to the class session for which the case is assigned.
2. In class, each group will meet for 10 to 15 minutes in different areas of the classroom. During that meeting, group members will take turns sharing their suggestions for the purpose of arriving at a single group treatment. 3. After the allotted time, a spokesperson for each group (selected during the group meetings) will share the
group’s solution with the class. The goal of the class is to incorporate the views of each group into a consen- sus approach to the situation.
Specifically, you should address:
a. Identify potential advantages to VIP of leasing the vans rather than purchasing them. b. How should the lease be classified by VIP? by Interstate?
c. Regardless of your response to previous requirements, suppose VIP recorded the lease on January 1, 2011, as a capital lease in the amount of $1,100,000. What would be the appropriate journal entries related to the capital lease for the second lease payment on December 31, 2011?
Research Case 15–2 FASB codification; locate and extract relevant information and authoritative support for a financial reporting issue; capital lease; sublease of a leased asset ● LO1 through LO5
CODE
Communication Case 15–3 Classification issues; lessee accounting; group interactionAmerican Movieplex, a large movie theater chain, leases most of its theater facilities. In conjunction with recent operating leases, the company spent $28 million for seats and carpeting. The question being discussed over break- fast on Wednesday morning was the length of the depreciation period for these leasehold improvements. The com- pany controller, Sarah Keene, was surprised by the suggestion of Larry Person, her new assistant.
Keene: Why 25 years? We’ve never depreciated leasehold improvements for such a long period. Person: I noticed that in my review of back records. But during our expansion to the Midwest, we don’t
need expenses to be any higher than necessary.
Keene: But isn’t that a pretty rosy estimate of these assets’ actual life? Trade publications show an average depreciation period of 12 years.
Required:
1. How would increasing the depreciation period affect American Movieplex’s income? 2. Does revising the estimate pose an ethical dilemma?
3. Who would be affected if Person’s suggestion is followed?
In concert with the International Accounting Standards Board, the FASB is rethinking accounting for leases. Because obligations to make operating lease payments contribute to a company’s riskiness, some accountants speculate that new lease standards might require leases now considered to be operating leases to be capitalized the way we now record capital leases.
Refer to the financial statements and related disclosure notes of Dell Inc., located in the company’s 2009 financial statements and related disclosure notes in Appendix B located at the back of the text. You also can locate the 2009 report online at www.dell.com . Find disclosure note 10, “Commitments and Contingencies.” Note the discussion of Dell’s lease commitments for certain of its property and equipment, manufacturing facilities, and office space.
Required:
1. What is the total of Dell’s operating lease commitments?
2. If the operating leases were capitalized, approximately how much would that increase Dell’s debt? [Assume a 6% interest rate and state clearly any other assumptions you make in your calculations.]
3. Referring also to Dell’s balance sheet, determine the effect that capitalizing the leases would have on the company’s debt-equity ratio.
Walmart Stores, Inc., is the world’s largest retailer. A large portion of the premises that the company occupies are leased. Its financial statements and disclosure notes revealed the following information:
Balance Sheet
($ in millions)
2009 2008
Assets Property:
Property under capital lease $5,341 $5,736
Less: Accumulated amortization (2,544) (2,594)
Liabilities Current liabilities:
Obligations under capital leases due within one year 315 316
Long-term debt:
Long-term obligations under capital leases 3,200 3,603
Required:
1. Discuss some possible reasons why Walmart leases rather than purchases most of its premises. 2. The net asset “property under capital lease” has a 2009 balance of $2,797 million ($5,341 − 2,544).
Liabilities for capital leases total $3,515 ($315 + 3,200). Why do the asset and liability amounts differ? 3. Prepare a 2009 summary entry to record Walmart’s lease payments, which were $603 million. 4. What is the approximate average interest rate on Walmart’s capital leases? (Hint: See Req. 3)
FedEx Corporation, the world’s largest express transportation company, leases much of its aircraft, land, facili- ties, and equipment. A portion of those leases are part of sale and leaseback arrangements. An excerpt from FedEx’s 2009 disclosure notes describes the company’s handling of gains from those arrangements:
Deferred Gains
Gains on the sale and leaseback of aircraft and other property and equipment are deferred and amortized ratably over the life of the lease as a reduction of rent expense.
Ethics Case 15–4 Leasehold improvements ● LO3 IFRS Case 15–5 Capitalizing operating leases; financial statement effects ● LO5 LO11 Real Word Case 15–6 Lease concepts; Walmart ● LO1 through LO6
Real World Financials
Real World Case 15–7
Sale-leaseback; FedEx
● LO10
Required:
1. Why should companies defer gains from sale-leaseback arrangements?
2. Based on the information provided in the disclosure note, determine whether the leases in the leaseback portion of the arrangements are considered by FedEx to be capital leases or operating leases. Explain. General Tools is seeking ways to maintain and improve cash balances. As company controller, you have proposed the sale and leaseback of much of the company’s equipment. As seller-lessee, General Tools would retain the right to essentially all of the remaining use of the equipment. The term of the lease would be six years. A gain would result on the sale portion of the transaction. The lease portion would be classified appropriately as a capital lease. You previously convinced your CFO of the cash flow benefits of the arrangement, but now he doesn’t under- stand the way you will account for the transaction. “I really had counted on that gain to bolster this period’s earn- ings. What gives?” he wondered. “Put it in a memo, will you? I’m having trouble following what you’re saying to me.”
Required:
Write a memo to your CFO. Include discussion of each of these points:
1. How the sale portion of the sale-leaseback transaction should be accounted for at the lease’s inception. 2. How the gain on the sale portion of the sale-leaseback transaction should be accounted for during the lease. 3. How the leaseback portion of the sale-leaseback transaction should be accounted for at the lease’s inception. 4. The conceptual basis for capitalizing certain long-term leases.
The following Trueblood case is recommended for use with this chapter. The case provides an excellent oppor- tunity for class discussion, group projects, and writing assignments. The case, along with Professor’s Discus- sion Material, can be obtained by searching for “Trueblood Cases” on the Deloitte Foundation website: www. deloitte.com .
Case 07-7: Porky’s Revenge
This case gives students the opportunity to extend their knowledge beyond chapter coverage by determining the lease commencement date. It focuses on a major issue in accounting for leases, but one which had often not been appropriately applied, resulting in incorrect accounting for many leases. It pertains to the situation described in the chapter in which over 200 companies in early 2005 accounted incorrectly for leases.
Security Devices Inc. (SDI) needs additional office space to accommodate expansion. SDI wants to avoid addi- tional debt in its balance sheet.
Required:
1. What lease classification would management prefer? Explain.
2. If SDI follows U.S. GAAP, how might SDI structure the lease agreement to avoid the additional debt? Explain.
3. Would avoiding the additional debt be more or less difficult under IFRS? Explain.
Communication Case 15–8
Where’s the gain?
● LO1 LO2 LO3 LO10 Trueblood Case 15–9 Lease inception date issues ● LO3 IFRS Case 15–10 Lease classification; U.S. GAAP ● LO1 LO2 LO3 LO11
BRITISH AIRWAYS CASE
British Airways, Plc. (BA), a U.K. company, prepares its financial statements according to International Finan- cial Reporting Standards. BA’s annual report for the year ended March 31, 2009, which includes financial state- ments and disclosure notes, is included with all new textbooks and can be found at www.britishairways.com . When answering questions, focus on BA’s “Group” financial information (which is equivalent to “Consolidated” under U.S. GAAP).
Required:
1. In Note 2: Summary of significant accounting policies, part d: Leased and hire purchase assets, BA states that “Where assets are financed through finance leases or hire purchase arrangements, under which substantially all the risks and rewards of ownership are transferred to the Group, the assets are treated as if they had been purchased outright.” Is this the policy companies using U.S. GAAP follow in accounting for capital leases? Explain.
2. Look at BA’s Note 28: Long-term borrowings and Note 29: Operating lease commitments. Does BA obtain use of its aircraft more using operating leases or finance leases? Do lessees report operating and finance lease commitments the same way? Explain.