C10-35
LANGSTON STACEY, INC.
Accounting for an Automobile Lease with a Residual Value Deficiency Clause
Langston Stacey, Inc. recently entered into an agreement to lease a new 20X1
luxury automobile from Shiretown Motors. The fair market value of the
automobile was $40,000 at the inception of the lease. Significant terms of
the lease are as follows:
The lease is for 18 months.
The monthly rental payable at the end of every month is $1,284.
The lessee is responsible for insurance, maintenance, and taxes.
The lessee at the end of the lease will be required to make up
any residual value deficiency on the automobile between $9,333
and $22,666, or a maximum of $13,333.
The lessee is limited to 24,000 miles driven over the 18 months.
The lessee will pay an additional charge of 25¢ per mile for all
miles in excess of the 24,000 mile limit.
Langston Stacey estimates that the economic life of the leased automobile is
three or four years. Langston has requested from Shiretown the implicit rate
of interest used in the lease, but Shiretown has refused to make that
information available. Langston's incremental borrowing rate is 1 percent
per month, which approximates the actual implicit rate in the lease.
Required
1. Discuss from the standpoint of each party how it should account for the
lease and why.
2. Did your response to question 1 appear to meet the objectives of the
GAAP for leases as established by the FASB?
3. Discuss how the parties should account for the lease if, instead of
requiring Langston to make up any residual value deficiency, the lease
required Langston to pay a fee to an unrelated third party to guarantee
a $22,666 residual at the conclusion of the lease.
4. Why would Shiretown Motors be willing to agree to the residual value
deficiency clause, which holds Langston Stacey potentially liable for
only a maximum of $13,333?
