Lease of super scan equipment of ‘See Through Inc’ and its proper

In answer to the requirement to make a recommendation after an analysis and the lease of Super Scan Equipment entered into ‘See Through Inc’ under a given case study[1], please consider this memo as formal way of presenting the results.  Based on my appreciation of the case study, there is a need to classify the lease of asset entered into on whether it is a direct financing, sales-type or operating lease with the added requirements to indicate the relevant advantages and disadvantages of each classification.

In addition, a determination how to account for the consulting services provided by the ‘See Through, Inc, the lessor in this case to the lessee will form part of this memo.  The resolution of the issue will be based on what the present US generally accepted accounting principles (US GAAP) or FASB Statement 13 say on the matter.   The following therefore are the possible options or classifications:

Option I – Treat as Operating lease

In a contract of lease, it is the lessee, who sets the tone on how to classify it first rather than the lessor. His or her choice is between operating lease and capital lease. For the lessee to say it is an operating lease, the same must have failed to classify it as a capital lease. Thus, the situation calls for answering the question: when will a lease be classified as capital lease?  Incidentally, FASB Statement No.13 has provided any of the four specified criteria to be to have a capital lease and they are: (1) The lease transfer ownership of the leased asset to the lessee at the end of the lease term (2) The lessee has the bargain purchase option.

(3) The lease term is for the major part of the economic life of the asset even if the title is not transferred; or (4)[2]. The present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset  at the inception of the lease. Using therefore the said set of criteria, there seems to be no hint that the lease was an operating lease since; there is an indication that the lease of equipment by See Through to Super Scan is covered under the third requirement.

Since it is required that compliance with any of four is sufficient to have a capital lease, then operating lease is indeed not possible. To support its classification into a capital lease, both the lease term and the expected life of the leased asset cover a period of 36 months, that is more than a year or long enough not to become an operating lease. As the lease term and the asset life are the same, the requirement of the third item in the set of criteria for the lease term to be at major part of the economic life of the asset has been deemed covered since the both are the same. It is not only therefore ‘major part’ but is already equal.

The logic of course behind the idea of having the lease term to be at least major part of the asset life is that, the fact the benefit has extended almost to the extent of the life of the asset, there is a seeming intention to use the asset as if it was owned in terms of beneficial use since the value of an asset is in the length of the time that one could benefit from it.

The issue of non-transfer of title although not much relevant anymore because of equal period of lease term and economic life of the assets at 36 months, is also confirmed by the incapacity of the lessee to sell, transfers, sells assign or sublease the equipment.

Since operating is technically an eliminated choice, it is proper to bring out its advantage and disadvantage still compared with capital lease. When one does not own something, one suffers no risk of loss. Paying for operating lease is therefore not paying as owner would-be or ‘substantially’ an owner would be. On the other hand, why pay what you will not own eventually? In other words, despite the risk of owning something, everybody as a rule wants to own a property if one can afford to have it.

Option II – Treat as Direct Financing lease

The wheel has been turned and it was found that is not an operating lease, but a capital lease, which could be either as direct financing lease of a sales type lease. The former treats differently the matter of initial direct cost which could be with the licensing and registration fees (or executory costs) in the case study[3].

To make a direct financing lease, the lessor shoulders initial direct cost or executory as a come-on provision in having the lease approved by the lessee the in negotiation. On other hand, sales type lease would have these initial costs as part of initially recognized expense[4] by the lessee in the latter’s the income statement at the inception of the lease.  The case study states that the lessee will pay for these initial costs[5]. Necessarily, I am forced to classify the contract a sales-type lease.

The advantage of capital over that of operating lease is the benefit of enjoying longer the use of property and which entrepreneurs value under the name of business stability. It disadvantage is the chance of losing something which one owns, or the risk of ownership if ownership would be transferred eventually by chance or putting wrong money in the wrong basket at a longer period.

Option III– Forced to have it as a Sales-type lease

The preceding section nicely made the analysis and presentation hence doing it again here would make it meaningless. But to emphasize that it was because of the payment of indirect cost by the lessee that the lease became as sales-type lease is just fair enough. Since sales type lease is also a capital lease, advantage must be deemed to have been discussed also earlier but for disadvantage the payment of initial costs should be considered in addition to disadvantage of direct financing lease.

Is the consultancy service provided lessor, a revenue or expense of either party? The discussion has left hanging or seeming issue of treating the consultancy service provided by the lessor during the term of the lease.  It was provides in the case that the consultancy will form part of the contract with no separate charging or billing by the lessor[6]. Being part therefore of the lease payment for 36 months, the provision of consultancy would just leave the parties unchanged in terms of cost or revenue on either parties, hence there is no need to give separate accounting treatment by recognition neither as revenue by lessor not expense by the lessee.

Conclusion and recommendation

The analyses could only lead to the necessary conclusion to have the contract as sales- type lease and not regarding the consultancy service as added cost or revenue.  FASB statement No. 13 as amended[7], provided the way how to resolve the issue by setting the criteria. As an accountant, I cannot contradict the conclusion analysis as I strongly recommend the same treatment to be accorded.  My recommendation for consultancy services will also in accordance with the conclusion, that is, not to regard the same as added cost or revenue any further.

Works Cited:

Deloitte Development LLC, Case Study for See Through, Inc.

FASB Statement No.13 Accounting for Leases, {www document} URL http://www.fasb.org/pdf/aop_FAS13.pdf, Accessed April 24, 2008

Meigs and Meigs (1995) Financial Accounting,  McGraw-Hill, New York, USA

[1] Deloitte Development LLC, Case Study for See Through, Inc. [2] FASB Statement No.13 Accounting for Leases, {www document} URL http://www.fasb.org/pdf/aop_FAS13.pdf, Accessed April 24, 2008 [3] Deloitte Development LLC, Case Study for See Through, Inc. [4] Meigs and Meigs (1995) Financial Accounting,  McGraw-Hill, New York, USA [5] Deloitte Development LLC, Case Study for See Through, Inc. [6] Deloitte Development LLC, Case Study for See Through, Inc.

[7] FASB Statement No.13 Accounting for Leases, {www document} URL http://www.fasb.org/pdf/aop_FAS13.pdf, Accessed April 24, 2008