Company A leases its equipment from Company B. In each of the following cases, a

Question

Company A leases its equipment from Company B. In each of the following cases, assuming none of the other criteria for capitalizing leases are met, determine whether the lease would be cpaital lease or an operating lease un FASB Statement No. 13. The decision is to be based only on the terms presented, considering each case independently.
a. The lease requires payment of $9,000 per year in advance plus executory cost of $500 per year. the lease perios is 3 years, and Co. A 's incremental borrowing rate is 12%. The fair value of the equipment is $28,000.
b. The lease requires payments of $6,000 per year in advance, which includes executory costs of $500 per year. The lease period is 3 years, and Company A's incremental borrowing rate is 10%. The fair value of the equipment is $16,650.

Explanation / Answer

Capitalization criteria: A lease should meet at least one of the four following criteria to be a capital lease. - Is there a transfer of ownership? - Is there a bargain in purchase option - Is term >75% of economic life? - Is present value of payments > 90% fair value? Let us consider the above criteria for the capitalization for each of the two alternatives. a. For the lease proposal a. - There is no transfer of ownership - There is no bargain in purchase option - didn't given  (due to lack of information) Let us calculate the present value of payments; Here the payment includes annual payment and executory costs Payment = $9,500 Present value factor at 3 years, 12% rate = 2.402 Present value of payment = 2.402 x 9,500 So present value of payment = $22,819 Fair value                             = 28,000 90% of fair value                  = 25,200 Here the present value of payment is less than 90% of fair value (22,819 < 25,200) As the lease alternative didn't meet at least one of the four criteria the alternative a is an operating lease.
b. For the lease proposal b. - There is no transfer of ownership - There is no bargain in purchase option - didn't given  (due to lack of information) Let us calculate the present value of payment; Here the payment includes annual payment and executory costs Payment = $6,500 Present value factor at 3 years, 10% rate = 2.487 Present value of payment = 2.487 x 6,500 So present value of payment = $16,165 Fair value                             = 16,650 90% of fair value                  = 14,985 Here the present value of payment is greater than 90% of fair value (16,165 > 14,985) As the lease alternative meet one of the four criteria the alternative b is a capital lease.

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