Question

Teal Mountain Fashion Company enters into a lease arrangement with Highpoint Leasing for 5 years. Teal Mountain agrees to pay 4% of its net sales as a variable lease payment. Teal Mountain does not pay any fixed payments. Teal Mountain is a highly successful company that has achieved over $1,900,000 in net sales over the last 7 years. Both Teal Mountain and Highpoint forecast that net sales will be a much greater amount than $1,900,000 in subsequent years. As a result, it is highly certain that Teal Mountain will make payments of at least $76,000 ($1,900,000 × 4%) each year.

What is the lease payment amount Teal Mountain should use to record its right-of-use asset?

Answer 1

Teal Mountain should use the forecasted minimum payment of $76,000 to record its right-of-use asset for the lease.

Step-by-step explanation:

The question pertains to a lease arrangement where the lease payment is determined as a percentage of the lessee's net sales. Specifically, Teal Mountain Fashion Company has agreed to a variable lease payment with Highpoint Leasing, set at 4% of its net sales.

Given that Teal Mountain has a history of net sales exceeding $1,900,000 and both parties anticipate that this trend will continue, the forecasted minimum lease payment is at least $76,000 annually ($1,900,000 × 4%). This amount represents the minimum expected payment and thus should be used by Teal Mountain to record its right-of-use asset for the lease under accounting standards.

By example, if we look at the Yoga Center scenario where the fixed and variable costs are weighed against revenues under different operating conditions, a similar thought process applies. In that scenario, if the Yoga Center earns revenues higher than the variable costs, it is beneficial to stay in operation. This example illustrates the importance of understanding both fixed and variable costs in making financial decisions related to lease agreements and business operations.