Cleveland Inc. leased a new crane to Abriendo Construction under a 6-year noncan

Question

Cleveland Inc. leased a new crane to Abriendo Construction under a 6-year noncancelable contract starting January 1, 2014. Terms of the lease require payments of $32,300 each January 1, starting January 1, 2014. Cleveland will pay insurance, taxes, and maintenance charges on the crane, which has an estimated life of 12 years, a fair value of $304,000, and a cost to Cleveland of $304,000. The estimated fair value of the crane is expected to be $46,100 at the end of the lease term. No bargain-purchase or renewal options are included in the contract. Both Cleveland and Abriendo adjust and close books annually at December 31. Collectibility of the lease payments is reasonably certain, and no uncertainties exist relative to unreimbursable lessor costs. Abriendo’s incremental borrowing rate is 11%, and Cleveland’s implicit interest rate of 11% is known to Abriendo.

Explanation / Answer

The lease is an operating lease to the lessee and lessor because:

          1.      it does not transfer ownership,

          2.      it does not contain a bargain purchase option

         3.      it does not cover at least 75% of the estimated economic life of the crane,         and

        4.the present value of the lease payments is not at least 90% of the fair value of   the leased crane.

          $32,300 Annual Lease Payments X PV of annuity due at 11% for 5 years

          $32,300 X 3.696 = $119380.80 which is less than $273600 (90% X $304000).

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