Question

Jefferson Inc. is in the process of negotiating a lease of equipment with a fair value of $200,000 and must determine the proper lease classification. The following table describes four scenarios under negotiation.

	1	2	3	4
Ownership Transfer	No	No	No	No
Lease term (years)	8	10	8	8
Asset’s useful life (years)	12	12	12	12
Asset’s fair value	$200,000	$200,000	$200,000	$200,000
Purchase option that is reasonably certain to be exercised?	No	No	$40,000	No
Alternative use of equipment at lease end	Yes	Yes	Yes	Yes
Payment Type	BOY	BOY	BOY	EOY
Annual lease payment	$25,000	$25,000	$25,000	$25,000
Lessor’s implicit rate (known by lessee)	Unknown	Unknown	5.4544%	Unknown
Lessee’s incremental borrowing rate	6%	6%	6%	6%
Guaranteed residual value	No	No	$50,000	No

Solution:

	1	2	3	4
Transfer of Ownership
Purchase option to be exercised?
Lease term > economic life
PV of lease payments > fair value
Specialized asset
Financing Lease (F) or Operating (O)

Determine the proper classification for each of the four scenarios using the solution grid above assuming that Jefferson Inc. is the lessee.

Answer 1

Lease classification for Lessee ( Jefferson Inc.)
	1	2	3	4
Transfer of Ownership	No	No	No	No
Purchase option to be exercised?	No	No	Yes	No
Lease term > economic life	No	No	No	No
PV of lease payments > fair value	No	No	No	No
Specialized asset	No	No	No	No
Financing Lease (F) or Operating (O)	Operating Lease	Operating Lease	Finance Lease	Operating Lease
Working for Present Value of lease payments:-
For option 1
Present Value of Annuity of Lease Payment	164,550	( 1 + 5.582 ) x 25,000
For option 2
Present Value of Annuity of Lease Payment	195,050	( 1 + 6.802 ) x 25,000
For option 4
Present Value of Annuity of Lease Payment	155,250	(25,000 x 6.210 )
For option 3
Present Value of Annuity of Lease Payment	193,485

Year	Lease payment & PO	Present Value @ 5.4544%	Present Value
1	25,000	1	25,000
2	25,000	0.948	23,700
3	25,000	0.899	22,475
4	25,000	0.853	21,325
5	25,000	0.809	20,225
6	25,000	0.767	19,175
7	25,000	0.727	18,175
8	25,000	0.690	17,250
Year end 8	40,000	0.654	26,160
Total	240,000		193,485