Question

Liesel Inc. is considering the following two separate leases. Each lease pertains to the lease of equipment with a fair value of $100,000.

	Lease One	Lease Two
Ownership of equipment transfers to lessee at lease-end	No	No
Lease includes a purchase option	No	Yes
Length of lease term	5	7
Economic life of the equipment	8	8
Alternative use of the equipment at lease-end	Yes	Yes
Annual lease payment, first payment due at end of each period.	$21,500	$18,000
Guaranteed residual value	$20,000	$0

Liesel Inc.’s incremental borrowing rate is 7% and is not aware of the implicit rate of either lease. For Lease One, the lessee estimates an expected residual value of only $12,000 of the equipment at lease-end based on its expected usage.

How would Liesel Inc. classify Lease One and Lease Two?

Lease One             Lease Two       

Question 3 options:

	Finance lease       Finance lease
	Operating lease   Finance lease
	Operating lease     Operating lease
	Finance lease     Operating lease

Answer 1

In order to differentiate between the two types of leases, one must consider how fully the risks and rewards associated with ownership of the asset have been transferred to the lessee from the lessor.

If these risks and rewards have been fully transferred, it is called a financing lease under IFRS Standards.Otherwise, it is an operating lease, which is basically the same as a landlord and renter contract.

At least one of the following criteria must be met in order to consider the lease a financing lease:

• There is a bargain purchase option – an option given to the lessee to purchase the asset at a price lower than its fair value at a future date (typically the end of the lease term). This option is usually determined at the beginning of the lease.
• The life of the lease is for a significant portion of the useful economic life of the asset (generally, 75% or more).
• The net present value (NPV) of minimum lease payments is at least 90% of the asset’s fair value.

Under Lease-1 the terms says that there should be no transfer of ownership rights, no inclusion of bargain- purchase option, the lease period is 62.5% i.e. less than 75% of economic life of asset. Therefore, it is clearly a case of Operating Lease.

Under Lease-2 , it contains an option of bargain-purchase of the asset, also it covers the 87.5% of economic life of the asset, Thus, we can say that it is a case of Finance Lease.

Thus, Lease-1 is Operating Lease and Lease-2 is Finance Lease.