He tells you that he stopped by the InXcess dealership today and has signed a lease for a brand new company car, the LuxuryMobile. He says that in order to impress the customers, he needs to have this special car. He explains to you that he has already signed the lease agreement. He tells you that you should “keep this lease off the balance sheet.” He says he knows that accountants know how to do things like that. He explains that he doesn’t want any grief from the board of directors and its “just easier this way.” He hands the document over to you and tells you that he has to leave the office now, as he has a dinner meeting with his favorite customer, Betty Beautiful. He pats you on the back and tells you to do

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some creative accounting to make sure this is taken care of the way he wants. He also alludes to the fact that Christmas bonuses could be very good this year.

You walk back to your office feverishly scanning the document. You haven’t run the numbers yet but you already know you may have a problem complying with your boss’s wishes. You get to your office, its 5pm, you really should call it a day but you know you won’t be able to sleep unless you’ve done the analysis on this lease and know what you are up against. The lease is non-cancelable and the document contains the following information:

Date of Lease Agreement: May 1, 2016 Annual lease payment due at the beginning of each year, beginning with May 1, 2016 $21,227.65 Bargain purchase option at end of lease term $ 4,000.00 Lease term 5 years Economic life of leased equipment 10 years Lessor’s cost $65,000.00 Fair value of asset at May 1, 2016 $91,000.00 Lessor’s implicit rate 10% Lessee’s incremental borrowing rate 10%

The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs.

As you suspected, the lease should be capitalized. You also discover that recording of this lease will have a negative impact on a key financial ratio that will put the company in default of a bank debt covenant.

Instructions:

Write a memo to your boss outlining your findings regarding this lease. Be sure to include the following:

a) Why you determined the lease should be capitalized (don’t be afraid to cite the FASB) b) A lease amortization schedule c) The journal entries that will be required to record the lease, make the first lease payment, and any other journal entries for 2016. d) An explanation of the disclosure requirements e) A proforma footnote disclosure for this lease f) Explain which financial ratio is affected by this lease that will put your company in default of its bank loan covenant. (You can make an educated guess here).

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You know that your boss is going to hit the roof when he reads this memo because the bank could “call the loan” when they find out that the company is in default of one of its loan covenants. (Don’t you love that? They make the mess and expect you to clean it up.) You really want to do everything possible to keep your boss happy (legally that is) because you really could use a substantial bonus this year. Therefore, you decide to include possible solutions to this bank loan covenant problem in your memo.

Feel free to add anything else you wish to this memo to make it interesting, fun, informational and creative.