Question

3. Marty McDonough is considering a 12-year (144-month) lease for manufacturing equipment with a life of 18 years. The minimum payments on the lease are $3,000 per month (or $36,000 per year); they are to be discounted back to the present at an 7% annual discount rate. The estimated fair value of the equipment is $350,000. Find (1) whether the lease is to be recorded as a capital lease or an operating lease; (2) show your computations and explain your reasoning.

Answer 1

3. There are two types of leases - Operating lease and Capital lease/Finance lease.

In operating lease, ownership of the asset is with the lessor during and after the lease term whereas in capital lease ownership might get transferred to the lessee at the end of the term. Operating lease is like renting of the asset whereas capital lease is more like a loan given.

There are various ways to identify if the arrangement is operating or capital lease. If the lease term is equal to or more than 75% of the life of the asset, it is considered to be a capital lease. According to present value criteria, if the present value of the lease payments is less than 90% of the equipment's fair value, then it is considered to be an operating lease.

In the given question, life of the asset is 18 years whereas lease term is 12 years which is around 66.67% of the life of the asset. Thus, according to lease term criteria, the lease is an operating lease.

To calculate the present value of the lease payments, we can use the below formula. I have considered annual payments for the calculation.

Present value = Payment in a year * (( 1-((1+interest rate)^-number of years))/interest rate)

= 36000 * ((1-(1.07^-12))/0.07)

=36000 * ((1-0.444)/0.07)

=36000 * (0.556/0.07)

=36000 * 7.942857

=$285943

The fair value of the equipment is $350000.

The present value of the lease payments is 285943/350000 = 81.7% of the fair value of the equipment. Thus, according to the lease payment criteria also, the arrangement is an operating lease since present value is less than 90% of the fair value of the asset.

Let me know if you have any doubt.