Question

Gerbil Leasing Company agrees to lease equipment to Playa Corporation on January 1, 2014. The following information relates to the lease agreement.

- The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.

- The cost of the machinery is $525,000, and the fair value of the asset on January 1, 2014, is $700,000.

- At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $50,000. Joseph estimates that the expected residual value at the end of the lease term will be $50,000. Playa amortizes all of its leased equipment on a straight-line basis.

- The lease agreement requires equal annual rental payments, beginning on January 1, 2014.

- The collectibility of the lease payments is probable.

- The lessor's implicit rate is unknown.

REQUIRED: Please show the calculation(s)/discussion of the test you use to answer the following questions:

1) What type of lease is this for the lessee?    

2) What type of lease is this for the lessor?   

Answer 1

The first classification option is a finance lease. This term is defined in the glossary as: From the perspective of a lessee, a lease that meets one or more of the criteria in ASC 842-10-25-2. These criteria are as follows:

a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
c. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

Conclusion-
Based on above priniciple (c), the lease term covers majority part of the economic life of the asset, i.e 77.78% (7/9*100). Since it satisfies one of the above condition, the above lease is classified as finance lease.
This classfication also holds good in the point of lessor. hence, it is finance lease also for the lessor.
Majority level is generally set as 75% unless contrary is proved, taking instances from earlier rules.