Question

Tzar Corporation entered into a lease agreement on January 1, 2010, to provide Playtpus Company with a piece of machinery. The terms of the lease agreement were as follows.

· The lease is to be for 3 years with rental payments of $10,521 to be made at the beginning of each year

· The machinery has a fair value of $55,000, a book value of $40,000, and an economic life of 8 years.

· At the end of the lease term, both parties expect the machinery to have a residual value of $30,000, none of which is guaranteed.

· The lease does not transfer ownership at the end of the lease term, does not have a bargain purchase option, and the asset is not of a specialized nature.

· The implicit rate is 6%, which is known by Playtpus.

· Collectibility of the payments is probable.

Required:

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

a. What type of lease is this for the lessee?

b. What type of lease is this for the lessor?

Answer 1

In the given question, the lease payments are made at the beginning of the year.

We need to find annuity due.

With 6% implicit rate of interest annuity due for 3 years is 2.8334.

Minimum lease payments = Periodic lease payments + Guaranteed Residual Value

Present Value of Minimum lease payments = 2.8334 x $10,521 + 0.8396 x $30,000

= $29,810.20 + $25,188

= $54,998.2

a. What type of lease is this for the lessee?

1. Ownership of the machinery is not transferred at the end of the lease

2. No written option for bargain purchase

3. 90% of the Fair value of the machine leased = $55,000 x 90% = $49,500

Present Value of Future minimum lease payments = $54,998.2

90% of Machine Fair Value < Present value of future minimum lease payments

4. 75% of machine economic life is not being commited in lease term.

Third condition is satisfied, hence the lease is capital lease for the lessee.

b. What type of lease is this for the lessor?

1. Criteria of Capital lease is met for the lessee;

2. Certainity for any unreimbuseable costs to be incurred. In this case there are no such costs

3. Collectability of lease payments is reasonably predictable, the collectibility is probable

Since all the above conditions are satisfied, the lease is Capital lease for the lessor.