On January 1, 2014, Von Company entered into two noncancelable leases for new ma

Question

On January 1, 2014, Von Company entered into two noncancelable leases for new machines to be used in its manufacturing operations.

The first lease does not contain a bargain purchase option; the lease term is equal to 80 precent of the estimated economic life of the machine.

The second lease contains a bargain purchase option; the lease term is equal to 50 precent of the economic life of the machine.

Required:

a. How should a lessee record each minimum lease payment for a capital lease?

b. How should Von classify each of two leases? why?

Explanation / Answer

Ans a Lessee record each minimum lease payment as follows:

All present value of lease payment is recorded as cost of the asset and credited to capital lease liability account. Now in each subsequent lease payment the amount is divided among two parts one is the interest portion which is treated as an expense and the remaining will be decreased from the capital leased liability. So with each payment interest expense is recorded and the capital lease libility is decreased which comes to zero at the end of the lease term.

Also note that the lessee will depreciate the asset like any other asset in his books.

Ans b Von wiill classify each of the two leases as capital lease, if any of the following criterio is met.

1) The period of lease covers at least 75% of the estimated economic life of the asset (First lease as it is 80% of economic useful life of the asset so falls under this criterio, as depreciable life of the asset is its economic life) or

2) Bargain purchse option: the lessee can buy the asset from the lessor at the end of lease term at a bargain price( second lease falls under this category as the lesseee has the bargain purchase option i.e the lessee can buy the asset at significanty lower price) or

3) the ownership is transferred to lessee at the end of the lease period. or

4) The PV of minimum lease payment equals or exceeds ninty percent of the fair value of lease asset

So 1 and 2nd criterio are met, so it is classified as capital lease

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