Question

Please use the information below to calculate the [1] 75% and 90% rule and [2] converting operating lease to capital lease. Question 1 - AAA corporation leases an asset to BBB corporation for 12 years beginning Jan 1, year 1 at annual rental of $7,000. The first payment is due at the beginning of the first year. The asset's economic life is 15 years and FMV of the asset at the inception of the lease $50,000. The lease require the BBB to pay $1,000 annual executory cost. The lease does not transfer ownership non contain a bargain purchase option. Interest 4%. Please use 75% and 90% to calculate qualification.

Answer 1

As per the current GAAP rules, a lease needs to be treated as a capital lease, if any of the below given four criterions is met:

1) Ownership of the leased asset transfers to the lessee upon completion of the lease.

2) There is a bargain purchase option in the lease.

3) The life of lease exceeds 75% of the economic life of the leased asset.

4) The present value of all the lease payments exceeds 90% of the fair market value of leased asset.

In the given question, since there is neither an ownership transfer nor a bargain purchase option available, first two criterions are not met. However, next two criterions still need to be tested.

Test of Criteria 3:

Percentage of the life of lease to the economic life of the lease asset = Life of lease / Economic life of asset
=> 12 Years / 15 Years = 0.8 or 80%

Since the life of lease exceeds 75% of the economic life, it qualifies as a “Capital lease”.

Test of Criteria 4:

Formula to calculate Present Value of equal cash-flow = Annual Cash-flow*{[1-(1+r)^-n] / r}

Where “r” is interest rate, and “n” is number of periods

Annual lease payment = Annual lease rental + Annual executory cost

=> $7,000 + $1,000 = $8,000

Present Value = $8,000*{[1-(1+0.04)^-12] / 0.04}
=> $8,000*{[1-0.62459705]/0.04}
=> $8,000*9.38507376049837 = $75,080.59

Since the present value of payments made towards lease exceeds the FMV of leased asset, it again qualifies as Capital Lease.