Interior Design Inc. (ID) is a privately owned business that produces interior decorating options for consumers. ID has chosen to follow private enterprise GAAP. The software that it purchased 10 years ago to present clients with designs that are unique to their offices is no longer state-of-the-art, and ID is faced with making a decision on the replacement of its software. The company has two options:
1. Enter into a lease agreement with Precision Inc. whereby ID makes an upfront lease payment of $12,000 on January 1, 2012, and annual payments of $4,500 over the next five years on each December 31. At the end of the lease, ID has the option to buy the software for $5,000. The first annual lease payment is on December 31, 2012.
2. Enter into a lease agreement with Graphic Design Inc. on January 1, 2012, whereby ID makes five annual lease payments of $6,500, beginning on January 1, 2012. ID may purchase the software at the end of the lease period for $200.
This is considered a bargain price compared with the offer of $5,000 in the proposal from Precision Inc. Under both options, the software will require annual upgrades that are expected to cost $1,500 per year. These upgrade costs are in addition to the lease payments that are required under the two independent options. As this additional cost is
the same under both options, ID has decided to ignore it in making its choice. The Precision agreement requires a licensing fee of $1,000 to be renewed annually. If ID decides on the Precision option, the licensing fee will be included in the annual lease payment of $4,500. Both Precision Inc. and Graphic Design Inc. offer software programs of similar quality and ease in use, and both provide adequate support. The software under each offer is expected to be used for up to eight years, although this depends to some extent on technological advances in future years. Both offers are equivalent in terms of the product and service.
It is now early October 2011, and ID hopes to have the software in place by its fiscal year end of December 31, 2011.
ID is currently working on preparing its third-quarter financial statements, which its bank is particularly interested in seeing in order to ensure that ID is respecting its debt-to-equity ratio covenant in its loan agreement with the bank. The interest rate on the bank loan, which is ID’s only source of external financing, is 10% per year. ID would have preferred to be in a position where it could buy rather than lease the software, but the anticipated purchase price of $30,000 exceeds the limits that the bank set for ID’s borrowing.
Instructions
(a) Discuss the nature of the lease arrangement under each of the two lease options offered to Interior Design and the corresponding accounting treatment that should be applied.
(b) Prepare all necessary journal entries and adjusting journal entries for Interior Design under the Precision Inc. option, from lease inception on January 1, 2012, through to December 31, 2012.
(c) Prepare an amortization schedule using a computer spreadsheet that would be suitable for the lease term in the Graphic Design Inc. option.
(d) Prepare all necessary journal entries and adjusting journal entries for Interior Design under Graphic Design’s option, from lease inception on January 1, 2012, through to January 1, 2013.
(e) Summarize and contrast the effects on Interior Design’s financial statements for the year ending December 31, 2012, using the entries prepared in parts (b) and (d) above. Include in your summary the total cash outflows that would be made by Interior Design during 2012 under each option.
(f) Discuss the qualitative considerations that should enter into Interior Design’s decision on which lease to sign. Which lease do you think will most likely be chosen by Interior Design? Why?
(g) What are the long-term and short-term implications of the choice between these two options? How do these implications support the direction in which GAAP is headed in the future concerning the accounting for leases?