Stirbis Company was negotiating a lease for a new building that would be used as a warehouse. Stirbis's accountant, Shannon Fenimore, had been invited to join Jim Stirbis (the president) in a meeting where the lease agreement was settled. The president of the company that owned the building said, I assume you want an operating lease.

That is correct, replied Jim.

The president responded, So we will not include a transfer of ownership or an option to purchase. Anyway, I am sure you do not want to get into the real estate business.

No, of course not.

And we agree that the lease term is 30 years.

Yes, but that seems to present some problems. We would have to argue that the life of the building is more than 40 years.

You should not have any trouble persuading your auditors to agree to that.

Maybe not. But the present value of the $53,040 annual lease payment is $500,000, which is the fair value of the building.

That is a problem. But I think I have a solution. We will adjust the annual payment to $45,000, so that the present value is only 85% of the fair value. Then we will add a clause that you also pay 1% of your total sales, up to a maximum of $8,040 each year.

Directions

1. Assuming that you are Shannon, research the generally accepted accounting principles and prepare a short memo to the president of Stirbis that summarizes how to classify the lease. Cite your reference and applicable paragraph numbers.

2. Decide whether or not a lease or purchase would be the best option for the item being considered for acquisition. Explain how the asset would be accounted for by purchase and what effect it would have on the financial statements.