Question

Each of the four independent situations below describes a lease requiring annual lease payments of $30,000.

	Situation 1	Situation 2	Situation 3	Situation 4
Lease term (years)	4	4	4	4
Asset's useful life (years)	6	6	5	6
Asset's fair value	$132,000	$114,000	$129,000	$115,000
Bargain purchase option?	No	No	Yes	No
Annual lease payments	Beg. of yr.	End of yr.	Beg. of yr.	End of yr.
Lessor's implicit rate (known by lessee)	5%	6%	6%	5%
Lessee's incremental borrowing rate	5%	5%	5%	5%

Required: For each situation, determine the appropriate lease classification by the lessee and indicate why. Round your answers to the nearest whole dollar amounts.

Answer 1

A lease is termed as Financial Lease it meets one of the following criteria:   

1. Lease Period is for 75% or more of the remaining economic life of the asset under lease.    2. Sum of the Present value of the Annual Lease Payments and Guranteed Residual value equals or exceeds 90 % of the FAIR VALUE of the Asset. 3. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

Situation 1. Financial Lease .Period of Lease = 4/6 i.e 67 % . Criteria 1 given above not met.    Sum of PV of Lease Payment= 30000* 4.546= 136380 > 1320000 i.e Fair Value, Criteria 2 met. Situation 2. Financial lease as Critera 2 met. Sum of PV of ALP is 30000*3.465 =103950 > 90% of 114000 Situation 3. Financial lease as option to purchase the asset at the end of lease period is with the lessee. Situation 4. Financial Lease as Criteria 2 is met.