Question

David Tennant Industries Inc leases TARDIS equipment from Matt Smith Equipment Corp for five years on 1/1/18 at $25,000 per year. The equipment has a five-year economic life. Lease payments are due on 12/31 of each year (not on 1/1 of each year). David Tennant Industries does not know Matt’s Smith’s implicit interest rate but their incremental borrowing rate is 5%. The lease conveys no transfer of ownership at the end of the term. There is no purchase option and no guarantee of residual value. Similar assets are depreciated on a straight-line basis.

David Tennant Industries also leases a sonic screwdriver from Song Industrial for three years starting 1/1/18. The machine has a fair value of $75,000, a 100-year economic life, and Song Industrial has other uses for it after the lease term. The lease calls for payment of $10,000 a year due on 12/31 of each year. The implicit rate is known and is 5%. The lease conveys no transfer of ownership at the end of the term. There is no purchase option and no guarantee of residual value.

 Determine the nature of the leases using the five-step process for the lessee.

 Create an amortization table for each of the leases

Answer 1

Solution:-      Matt Smith Song Industrial

Five Steps Equipment:-

1. The lease transfers ownership of the underlying asset

to the lessee by the end of the lease term NO   NO

2. The lease grants the lessee an option to purchase the underlying

asset that the lessee is reasonably certain to exercise NO NO

3. 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 YES NO

4. 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, YES NO

this criterion shall not be used for purposes of classifying the lease

5. The present value of the sum of the lease payments and any residual

value guaranteed by the lessee equals or exceeds substantially all YES NO

of the fair value of the underlying asset

If any of the one condition is satisfied then it is financial lease, otherwise operating lease.

Hence Matt Smith Equipment is consider as a financial lease & Song industrial is classified as operating lease

Ammortisation Table:-

Fair value of asset( Present value )= 25000 * PV factor@ 5 % = 25000* 4.329 = 108236.91

Period	Cash	Exp	Liab Reduction	Balance Liab
1	25000	5411.845	19588.155	88648.75
2	25000	4432.437	20567.56	68081.18
3	25000	3404.059	21595.94	46485.24
4	25000	2324.262	22675.74	23809.50
5	25000	1190.49	23809.50	0