Question

Atlanta Tours Company entered into a five-year lease on January 1, Year 1, with Duck Boats, Inc. for a customized duck boat. Duck Boats, Inc. will provide a vehicle to Atlanta Tours Company with the words "Gone with the Wind" carved into the sides. Following are the terms of the lease arrangement.

•Fair value of the wagon at the inception of the lease is $10,000

•There is an eight-year estimated economic life

•Estimated (unguaranteed) residual value is $3,500. Atlanta Tours Company does not absorb any gains or losses in fluctuations of the fair value of the residual value.

•Annual lease payments of $2,000 are due on January 1 of each year. The implicit interest rate in the lease is 6 percent.

•There is an option to purchase at end of lease term for $4,000.

•The lease is noncancelable and may not be extended.

Required:

1.Discuss whether Atlanta Tours Company should classify this lease as an operating lease or as a finance lease under (a) IFRS and (b) U.S. GAAP.

2.Discuss your reasoning. Do not forget to include proper APA formatting and citation where necessary.

Answer 1

Under U.S GAAP, the classification of Lease (e.g., operating, capital) depends on whether the lease meets certain criteria. ASC 840-10-25-1 indicates that a lessee classifies a lease as a capital lease if it meets one or more of the following criteria:

1. Ownership: The ownership of the asset is shifted from the lessor to the lessee by the end of the lease period; or
2. Bargain purchase option: The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or
3. Lease term: The period of the lease encompasses at least 75% of the useful life of the asset (and the lease is noncancellable during that time); or
4. Present value: The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.

If none of the criteria are met, the lease is classified as an operating lease.

But in present case, present value of the lease payments does not exceed 90% of the fair value of the asset.

Hence, it should be classified as operating lease.

Under IFRSs, the classification of a lease does not depend on whether specified criteria are met or not. Rather, the classification depends on whether the lease is in substance an operating lease or financial lease. Atlanta Tours Company should consider multiple factors to determine classification of this lease. Since the transaction fails most of the criteria for finance, this lease is an operating lease. Most of the criteria for operating lease are clearly met, the following are factors that are not immediately clear.

The five year lease term might be considered a “major part” of the eight year expected life of the asset. The minimum lease payments are 89.3% of the fair value of the property, which could be considered “substantially all” of its value. Lastly, the custom carving could make the asset “specialized”, and only after considering revision/resurfacing could this criterion be measured.