Big Bear Case Study

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The Bear Minimum Summary Big Bear Power Company is a public utility. Big Bear has had several profitable years and is in compliance with all its debt covenants. On December 15, 2004 Big Bear signs a lease with Goliath Company for a combustion turbine. Big Bear will take possession of the turbine on January 1, 2005. Terms of the lease are: 1. 10 year non-cancelable term. 2. Big Bear must pay Goliath Company’s legal fees of $1,000,000 which were incurred in negotiation of the lease. 3. A penalty payment will be incurred by Big Bear if there is a “material adverse change” in its financial condition. The term “material adverse change” is not defined in the contract. 4. Big bear’s annual lease payments will be $1,000,000…show more content…
Having this knowledge, Big Bear agreed to a default provision in their lease contract. The provision calls for a penalty payment if Big Bear’s financial condition suffers a “material adverse change”. In-line with customary provisions in leasing the “material adverse change” is not defined. From ASC 840-10-25-14 we find four conditions that must be met in order for a penalty payment to be excluded from the minimum lease payment. All four of the conditions must be met to have the penalty payment excluded from the minimum lease payment. The first test is whether the default provision is customary in financing arrangements. Big Bear’s lease contract meets this condition. The second condition is whether the cause for the default can be objectively determined. Big Bear’s lease contract states that if Big Bear’s financial condition suffers a material adverse change, they would be in default. This is objectively determinable. The third condition is that predefined requirements that pertain solely to the lessee have been established which will determine if default has occurred. In Big Bear’s case the “material adverse change” is not predefined. Therefore the third condition has not been met and the penalty payment would be included in the minimum lease payment. Since Big Bear’s lease agreement has failed condition three of ASC 840-10-25-14 c there is no need to continue to the next

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