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TopNotch Medical, Inc , is a supplier of medical equipment It recen

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TopNotch Medical, Inc., is a supplier of medical
equipment. It recently introduced a new line of equipment
that may revolutionize the medical profession. Because of
the new technology, potential users of the equipment are
reluctant to purchase the equipment, but they are willing to
enter into a lease arrangement if they can classify the
lease as an operating lease. The new equipment will
replace equipment that TopNotch has been selling in the
past. Leasing the new equipment will result in losing an
estimated 25% in equipment sales.
Some members of management want to structure the
leases so that TopNotch, as lessor, can classify the lease
as a sales-type lease and thus avoid further reduction of
income. Others believe that they should treat the leases as
operating leases and minimize the income tax liability in
the short term. They are uncertain, however, as to how the
financial statements would be affected under these two
different approaches. They also are uncertain as to how
leases could be structured to permit the lessee to treat the
lease as an operating lease and the lessor to treat it as a
sales-type lease. As the accountant for TopNotch, explain
how TopNotch should record the leases. Be sure to
support your rationale.
Solution
In practice, the difference between a sales type lease and
a direct financing lease is pretty minimal. Both types are
considered capital leases, meaning the lessor finances the

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leased asset but all the rights to ownership transfer to the
lessee. This is a common financial arrangement for
equipment, real estate, and many other asset types.
In the accounting sense, however, the difference between
the sales type and the direct financing type are quite
different.
Accounting for a direct financing lease
In a direct financing lease, the lessor accounts for the
income from the sale over time as the lease payments are
made. When the asset is leased, the lessor removes the
asset\'s book value from its balance sheet and replaces it
with a receivable equal to the book value. The internal rate
of return on the asset -- the difference in cash flows from
all the monthly payments less the book value of the asset
when it was sold -- is used as the implied interest rate for
the lease.
This arrangement is analogous to how a bank would
account for a loan. Each month, the loan payment is paid,
and the bank recognizes the interest portion of the
payment as income and the principal portion goes to
reduce the loan\'s balance.
As each payment is received in the direct financing lease
arrangement, the lessor records income based on the
implied interest portion based on the asset\'s internal rate
of return and the remainder would be netted from the

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TopNotch Medical, Inc., is a supplier of medical equipment. It recently introduced a new line of equipment that may revolutionize the medical profession. Because of the new technology, potential users of the equipment are reluctant to purchase the equipment, but they are willing to enter into a lease arrangement if they can classify the lease as an operating lease. The new equipment will replace equipment that TopNotch has been selling in the past. Leasing the new equipment will result in losing an estimated 25% in equipment sales. Some members of management want to structure the leases so that TopNotch, as lessor, can classify the lease as a sales-type lease and thus avoid further reduction of income. Others believe that they should treat the leases as operating leases and minimize the income tax liability in the short term. They are uncertain, however, as to how the financial statements would be affected under these two different approaches. They also are uncertain as to how leases could be structured to permit the lessee to treat the lease as an operating lease and the lessor to treat it as a sales-type lease. As the accountant for TopNotch, explain how TopNotch should record the leases. Be sure to support your rationale. Solution In practice, the difference between a sales type lease and a direct financing lease is pretty minimal. Both types are considered capital leases, meaning the lessor finances the leased asset but all the rights to ownership transfer to the less ...
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