In the extremely cold months of the winter of 2004 the Smith Corporation entered into a lease that could not be canceled according to its terms spanning eight years for a magnetic resonance imaging system. The terms of the lease required payments of $15,000 on the first of each year. At the time the lease began, the Smith Corporation was well aware that this particular machine had a useful lifespan of twelve years. After twelve years it was also understood that the machine would have no salvage value. According to the lease agreement the title to the machine would pass to the Smith Corporation when the lease expires.
The Smith Corporation hired a CPA Salt Lake City to look over the deal. Because the Smith Corporation employs straight-line depreciation for all of the machines and other equipment it owns. The certified public accountant determined that the aggregate lease payments had a value of $108,000 in the winter of 2004. This calculation was made based on the current interest rate.
The Chief Executive Officer of the Smith Corporation had a meeting with his CPA Salt Lake City for the purpose of asking what rate the Smith Corporation should record the depreciation or amortization expense for the year 2004. The CPA told the CEO that under no circumstances would the number be $0. He explained that the Smith Corporation must depreciate the machine because according to the terms of the lease the title passes to the Smith Corporation which causes the lease to become capitalized. No, because title to the machine will pass to the Smith Corporation, the Smith Corporation will have to depreciate the machine over its useful life which had been determined to be twelve years. Accordingly, the depreciation expense would be $9,000 as $108,000 divided by twelve is $9,000.