Question

At January 1, 2018, Café Med leased restaurant equipment from Crescent Corporation under a nine-year lease agreement. The lease agreement specifies annual payments of $26,000 beginning January 1, 2018, the beginning of the lease, and at each December 31 thereafter through 2025. The equipment was acquired recently by Crescent at a cost of $189,000 (its fair value) and was expected to have a useful life of 13 years with no salvage value at the end of its life. (Because the lease term is only 9 years, the asset does have an expected residual value at the end of the lease term of $27,160.) Crescent seeks a 8% return on its lease investments. By this arrangement, the lease is deemed to be an operating lease.

Answer 1

GAAP rules state that to determine whether the lease is an operating lease, the following characteristics must be checked:

1. The life of the lease must not be longer than 75% of the life of the asset.

2. The lessor cannot transfer ownership of the asset to the lessee at the end of the lease term.

3. There cannot be an option to purchase the asset at a "bargain price" at the end of the lease term.

4. The present value of the lease payments cannot exceed 90% of the fair market value of the asset.

Check for point 1.

Lease is for 9 years and life of asset is 13 years.

So Lease covers 9/13*100 = 69% of life of asset . Hence according to point 1 it is an operating lease.

Check for point 2 and 3:

As per above arrangement, lessor will not transfer the asset at end of lease term, nor their option to leasee to purchase the asset at bargain price

Check for point 4:

Residual value is not considered as it is not gauranteed by leasee

Calculation of present value of lease payments:

Lease payments date	Lease payment	Discounting factor at 8%	Present value
1st jan 2018	26000	1	26000
31st dec 2018 to 31st dec 2025	26000	6.031375429	156815.761
		Total	182815.761

% of fair value = 182815.761/189000*100 = 96.73%

Lease payments exceeds 90% of fair value. Hence the lease is finance lease.