Sylvan Inc. entered into a non-cancelable lease arrangement with Breton Leasing Corporation for a certain machine. Breton’s primary business is leasing; it is not a manufacturer or dealer. Sylvan will lease the machine for a period of 3 years, which is 50% of the machine’s economic life. Breton will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Sylvan does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term. Sylvan’s incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Sylvan has no way of knowing the implicit rate used by Breton. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement. Sylvan has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Breton is reasonably certain that Sylvan will pay all lease payments, and because Sylvan has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Breton. Assume that no indirect costs are involved.

(a) With respect to Sylvan (the lessee), answer the following.

(1) What type of lease has been entered into? Explain the reason for your answer.

(2) How should Sylvan compute the appropriate amount to be recorded for the lease or asset acquired?

(3) What accounts will be created or affected by this transaction, and how will the lease or asset and other costs related to the transaction be matched with earnings?

(4) What disclosures must Sylvan make regarding this leased asset?

(b) With respect to Breton (the lessor), answer the following:

(1) What type of leasing arrangement has been entered into? Explain the reason for your answer.

(2) How should this lease be recorded by Breton, and how are the appropriate amounts determined?

(3) How should Breton determine the appropriate amount of earnings to be recognized from each lease payment?

(4) What disclosures must Breton make regarding this lease?

(AICPA adapted)