Question

On January 1, 2020, Nivtop Corp. leased a machine from Nosnah Inc. The lease agreement calls for
Nivtop to make four annual lease payments of $559,113 each January 1, with the first payment to be
made on January 1, 2020. Nivtop’s incremental borrowing rate is 8%; this is the same rate Nosnah
used to calculate the lease payments. The fair market value of the machine is $2,000,000 and its
expected useful life is 5 years. This is a non-specialized machine.
Nosnah purchased the machine from a vendor on December 31, 2019 for $1,573,000.
Required
a. List the 5 criteria used to determine whether a lease qualifies as finance/sales-type or
operating. Review each criterion to determine which (if any) this lease meets.
b. What type of lease is this for Nivtop?
c. What type of lease is this for Nosnah?
d. Show all of Nivtop’s journal entries relative to this lease at
1) January 1, 2020
2) December 31, 2020
3) January 1, 2021
e. Show all of Nosnah’s journal entries relative to this lease at
1) January 1, 2020
2) December 31, 2020
3) January 1, 2021

Answer 1

a) The five criteria used to determine whether a lease qualifies as a finance/sales-type or operating are as below

1. Ownership- whether the ownership of the asset is transferred to the lessee by the lessor
2. Buying option- Lessee has the option to buy the asset which we can certainly say that is can be exercised by the lessee
3. Lease duration: Lease covers the major portion of the expected useful asset life. * Usually if the lease term covers 75% or more of the useful life we consider that a major portion has been covered
4. Special nature of asset : The asset leased has no use to the lessor at the end of the lease term due to the special nature of the asset
5. Lease term: The present value of lease term payment covers majority of the fair value of the leased asset

Based on the above 5 criteria if a lease term fulfillls even one of the above criteria, it qualifies as Finance lease (For the lessee) sales type lease for the lessor. If none of the criteria is met the lease qualifies as Operating Lease. To understand this more please note that in case of Finance lease, the risk and reward of leasing asset are trasferred to the lessee however, the transfer of tilte to the lessee may or maynot happen.

As we can know from the information provided, the machine has been leased for 4 years for a lease payment of $559,113 each year, the useful life is of 5 years with a purcharse cost of $1573,000 and fair value of $ 2000,000, and that is a non- specialized machine.

So, we can see that the lease meets criteria 3 ( 80% of the useful life) and 5( PV is 100% of the fair value ) and thus this will classify as Finance/Sales-Type lease.

b) For Nivtop as it is a Lessee it will be a Finance Lease

c) For Nosnah as it is the lessor it will be a Direct finance Lease (In case of IFRS it will be a sales type lease)

d) Calculating PV of the lease payments using the the formula below

PV = Lease payment * {1+ [1- (1+r)^-(t-1)]/r}

This comes out to be equal to $ 2000001

And the journal entries will be as below: