Question

Valese Inc. leased standard equipment to Linus Corporation with a lease period of 8 years. At the end of the lease Valese is to have possession of the equipment. Valese paid $16,000 for the equipment. The useful life of the equipment is 12 years. The normal sale price of the equipment is $22,500. The present value of the lease payments for the lessor and lessee is $20,500. The first payment was made the day the lease was signed. What are the five criterial for classification as a finance lease? Can Linus classify this as a finance lease? If yes, which criteria it met for a finance lease?

Answer 1

In order to classify a lease as a finance lease, the lease must meet just one of the 5 criteria listed below:

(i) Ownership transfers at the end of the lease term.

(ii) There is a written option for bargain purchase in the lease.

(iii) The present value of the lease payments is > 90% of the fair value of the leased property.

(iv) The lease term is >75% of the asset's useful life.

(v) The leased asset should be of such a specialized nature that it should not have alternative use to the lessor at the end of the lease term.

Now, let us see each criteria above to check whether the lease given in the question is a finance lease.

(i) There is NO ownership transfer at the end of lease term.

(ii) There is NO written option for bargain purchase in the lease.

(iii) The present value of the lease payments is > 90% of the fair value of the leased property = YES

Present value of lease payments = $20500

Fair value of property = $22500

90% of fair value = 90% * $22500 = $20250

(iv) The lease term is >75% of the asset's useful life = NO

Lease term = 8 years

Useful life of equipment = 12 years

75% of useful life = 75% * 12 = 9 years

(v) The leased asset should be of such a specialized nature that it should not have alternative use to the lessor at the end of the lease term = NO

This lease is a finance lease because it met the criteria of :

The present value of the lease payments is > 90% of the fair value of the leased property.