Reference no: EM131346583
Officials of Danville, determining that the city needed additional administrative space, decided to acquire an available office building. Aware that city voters were unlikely to approve a bond issue to finance the purchase of the building, they decided instead to lease the property.
If the city had purchased the building outright, the acquisition price would have been $5 million. If it had issued general obligation bonds at the prevailing interest rate of 6 percent and elected to service the debt with equal payments over 20 years, then annual interest and principal payments (assuming annual compounding) would have been $435,923. The city arranged for a financial institution to purchase the building and lease it to the city for 20 years. The lease specified annual payments of $435,923 and gave the city the option to purchase the building for $1 at the expiration of the agreement. The financial institution would sell shares in the lease to the public, just as if the city had issued bonds to acquire the building. The lease also contained a nonappropriation clause stipulating that the city would make ‘‘good faith’’ efforts to adhere to its payment schedule but that its obligation was limited to amounts that the city council appropriated annually.
1. Prepare a journal entry to reflect acquisition of the building by lease in the city’s government-wide statements.
2. Prepare journal entries to record the first lease payment and the first year’s depreciation (assuming a 20-year useful life). Indicate how the entries to record the second lease payment would differ from the first.
3. Suppose you were asked to represent the Danville Taxpayers Association, a group of citizens opposed to the acquisition of the building. The association contended that under the city’s charter, the city was required to obtain voter approval for all general obligation debt over $1 million. The lease, it said, was the equivalent of general obligation debt. Therefore, it charged, the lease violated the city’s charter and should be voided. What arguments would you make in support of the association’s position?
4. Suppose, instead, that you were asked to represent the city. What arguments would you make to support the contention of city officials that the lease is not the equivalent of general obligation debt?
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