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In: Accounting

As the recently hired junior accountant for Norman, Inc, you have just completed your initial review...

As the recently hired junior accountant for Norman, Inc, you have just completed your initial review of the financial statements. During this review, you discover a used vehicle recently recorded as an operating lease. The lease agreement was entered into a year ago. You decide to review the lease agreement to ensure that the lease should be afforded operating lease treatment, and you discover the following: Non-cancelable term of 4 years. Rental of $3,240 per year (at the end of each year). (The present value at 8% per year is $10,731). Estimated residual value of $1,100 is guaranteed. Estimated economic life of the automobile is 5 years. Norman's incremental borrowing rate is 8% per year. Initial Post In your discussion, evaluate the criteria for classification of the lease, and describe the nature of the lease.

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Expert Solution

Solution:

Generally, there are two type of lease agreement. One is operating lease and the other one is finance lease. In fiancé lease the lessee will enjoy all the benefits of the assets. And the lease agreement which is not finance lease is operating lease. In finance lease the economic life and the present value of the lease rental is 90% or more of the total assets cost. But in case of operating lease the same should be less than the finance lease. The assets under finance lease is completely use by the lessee. Only the depreciation tax shield and ownership are enjoyed by the lessor. To identify the nature of the lease, lease tenure and the present value of the lease rental is considered. If these are more than 90% in case of assets cost and more than 75% in case of lease tenure, then in that case it will treat as a finance lease.

In the instant case the total economic life of the assets (vehicle) is 5 years and the lease tenure is 4 years. So the lease tenure is 80% of the total economic life of the assets. In other hand the present value of the total lease rental is $12,936 plus present value of the guaranteed residual value is $748.64. This is more than the total asset (vehicle) cost. So the instant lease agreement is a finance lease agreement.

References:

Altamuro, J., Johnston, R., Pandit, S., & Zhang, H. (2014). Operating leases and credit assessments. Contemporary Accounting Research, 31(2), 551-580.

Cosci, S., Guida, R., & Meliciani, V. (2015). Leasing decisions and credit constraints: Empirical analysis on a sample of Italian firms. European Financial Management, 21(2), 377-398.

ekkarill92 answered 2 years ago
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