Topango Case Study

Premise lease:

The premise lease for Topango should be recognized as an operating lease for accounting purposes under ASPE. The premise lease is categorized as such because it does not meet all three requirements in order to be classified as a financing lease (ASPE Section 3065.06). Zero out of the three requirements are met, and as such Topango’s premise lease shall be disclosed as an operating lease.

The first of the three criteria are as follows: there is reasonable assurance that the lessee will obtain ownership of the property at the end of the lease. This is not true for Topango as Topango was not offered a bargain purchase option as part of the lease agreement.  The second criteria is: the lessee will receive most of the asset’s benefits based on its useful life (more than 75%). Again this criteria is not met as Topango is only leasing the building for four years, which it can be assumed that the buildings useful life will be greater than 6 years therefore Topango will not receive most of the assets benefits. The third and final criteria is: the lessee will recover substantially all of its investment. This is not true for Topango as the present value of Topango’s minimum lease payments is not greater than the asset’s fair value (calculation shown in Appendix 1.A).

Now that we have established that the premise lease is classified as an operating lease, we can determine how it should be shown on the books. First Topango would have to record the journal entry for the lease payment at the beginning of each month. There is a debit to Prepaid Rent as Topango is paying the rent at the beginning of each month however the rent is not actually being fully used up until the end of the month.

Oct 1 2015        DR Prepaid Rent        $9350

CR Cash                 $9350

The above journal entry would be recorded on the first date of every month until the end of the lease term (until Sept. 1, 2019). The next entry that requires an entry is the write-off of the expense and the diminishment of the prepaid expenses. (ASPE Section 3065.24)

Oct 31                 DR Rent Expense        9350

                        CR Prepaid Rent        9350

This entry would be recorded on the last date of every month until the end of the lease term (until Sept. 31, 2019).

There are minimal effects that the premise lease will have on Topango’s financial statements. The only affect is to the Income Statement. Five months’ worth of rent expense would have been incurred by 2016 year end. This amounts to a rent expense of $46,750 ($9,350/month x 5 months). All prepaid rent would have been written-off by year end.

Printing Press Lease: 

The printing press lease for Topango should be recorded as a financing (or capital) lease as it meets the requirements. Under ASPE, the printing press lease clearly meets one of the three requirements (ASPE Section 3065.06). That is: Topango will recover substantially all of their investment in the printing press. This is met because the present value of Topango’s lease payments is greater than 90% or the fair value of the asset (the present value of lease payments is shown in Appendix 1.B). The present value of payments is clearly greater than 90% of the printing press’ fair value ($420,000x 90% = $378,000) as the present value of the payments is $411,580.