Question

ABC Company leased a tooling machine on January 1, 2018, for a four-year period ending December 31, 2021. The lease agreement specified annual payments of $25,000 beginning with the first payment at the beginning of the lease, and each December 31 through 2020. The company had the option to purchase the machine on December 30, 2021, for $16,000 when its fair value was expected to be $24,000 a sufficient difference that exercise seems reasonably certain. The machine's estimated useful life was six years with no salvage value. ABC was aware that the lessor’s implicit rate of return was 10%. The amortization of the right-of-use asset in 2018 ABC income statement should be:

a. $15,475
b. $20,645
c. $16,350
d. $24,500

Answer 1

Introduction

The above stated question is a question of lease accounting. Leases are classified into 2 types namely:

- Finance lease and

- Operating lease.

There are certain indicators where a lease is classified as finance lease. Some of the indicators are:

1. There is a transfer of ownership at the end of the lease period to the lessee

2. The minimum lease payments cover substantially the whole of the fair value of the assets

3. The lessor gives the lessee a right to purchase the leased asset at the end of lease period at a price much lower than its fair value, such that it is certain that the lessee will exercise the option of purchasing the asset.

In case the lease is a finance lease, the leased asset should be capitalised at lower of the following 2:

- present value of lease payments over the lease period

Solution:

Based on the above set criteria's, the following criteria's of a finance lease are satisfied:

- The lessor gives the lessee a right to purchase the leased asset at the end of lease period at a price much lower than its fair value, such that it is certain that the lessee will exercise the option of purchasing the asset. (The lessee can purchase the asset for 16,000 whereas its fair value is 24,000)

- The minimum lease payments cover substantially the whole of the fair value of the assets - the present value of minimum lease payments is 87,170 (Refer calculation in Note 1) which covers substantially whole of the fair value of the assets

Hence, based on above, the lease is a finance lease.

The lease asset will be recorded at lower of:

- Fair value - 24,000 in the current case and

- Present value of minimum lease payment which is 87,170.

Hence, the lease asset will be recorded at 24,000. Hence,option d is the correct option

Note 1

Calculation of present value of minimum lease payments

Date	Particulars	Amount	Discounting factor at 10%	Net Amount
		(A)	(B)	(C=A*B)
01-01-2018	Annual payments	25,000	1	25,000
31-12-2018	Annual payments	25,000	0.9091	22,728
31-12-2019	Annual payments	25,000	0.8264	20,660
31-12-2020	Annual payments	25,000	0.7513	18,783
			Total	87,170