Question

Consider the following terms of a lease.

1. The lease term is 5 years. The lease is noncancelable and requires equal payments of $50,000 at the beginning of each year, beginning January 1, 2019.
2. The leased asset is a standard piece of equipment.
3. The cost, and fair value, of the equipment to Lessor at the inception of the lease is $350,000. The equipment has an estimated economic life of 10 years and has a zero estimated residual value at the end of this time.
4. There is no guarantee of the residual value by Lessee.
5. The lease contains no purchase option and no agreement to transfer ownership at the end of the lease.
6. Lessee's incremental borrowing rate is 12% per year. Lessee is not able to determine the interest rate implicit in the lease.
7. The present value of an annuity due of 5 payments of $50,000 each at 12% is $201,867.45 (4.037349 × $50,000 = $201,867.45).

How does the lessee classify the lease?

Finance lease

Sales-type lease

Operating lease

This is not a lease

Answer 1

A lease is classify as either operating lease or finance lease, lease is classified as finance elase if risk and reward incidental to ownership are transferred.if lease is not finance lease it is considered operating lease

Risk and reqard are considered to be transferred if any of five conditions are to be met as defined by gaap which are as follows

• The asset transfers to the lessee at the end of the lease term automatically
• The lessee has an option to purchase the asset from the lessor at below fair value at the end of lease term
• The lease term is for a significant part of the asset’s useful economic life
• The present value of future lease payments amounts to substantially all of the asset’s fair value
• The leased asset is specialised in nature, and may only suit the needs of the lessee without major modification

In the given case

The lease has no purchase option and also ownership is not transfeered at end of lease term so condition 1&2 are not met.

Also the assets economic life is 10 years while life of asset is 5 years, so the third condition also not met.

The present value of future lease payment is 201,867.45 and fair value of asset value is 350,000 so the fourth condition also not fullfilled as lease payments do not substantially cover fair value.

The asset is standard equipment and to of specialised nature according to lesse needs.

Since no condition is met lease is not a finance lease and is thus an operating lease.