Question

Macinski Leasing Company leases a new machine to Sharrer Corporation. The machine has a cost of $70,000 and fair value of $95,000. Under the 3-year, non-cancelable contract, Sharrer will receive title to the machine at the end of the lease. The machine has a 3-year useful life and no residual value. The lease was signed on January 1, 2020. Macinski expects to earn an 8% return on its investment, and this implicit rate is known by Sharrer. The annual rentals are payable on each December 31, beginning December 31, 2020.

(a)

Discuss the nature of the lease arrangement and the accounting method that each party to the lease should apply.

Answer 1

Nature of Lease Agreement:

For Lessee,

The lease is a capital lease after considering the following things

1. The ownership is being transferred to the lessee after lease.

2. The lease term is longer than 75% of the economic life of the asset.

3. The present value of the minimum lease payments is more than 90% of the fair value of the asset.

For Lessor,

The lease is a financing lease after considering the following things

1. Assuming the collectibility of the rents is reasonably assured.

2. No important uncertainties surround the number of unreimbursable costs yet to be incurred by the lessor.

The accounting method:

For Lessee,

The lessee should adopt the capital lease method and record the leased asset and lease obligation at the present value of the minimum lease payments using the lessee’s incremental borrowing rate.

For Lessor,

The lessor should adopt the direct financing lease method and replace the asset cost with Lease Payments Receivable.