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CA21-3 (Lessee Capitalization Criteria) On January 1, Santiago Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Santiago at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, is 75% of the fair value of the equipment. The following information is peculiar to each lease. 1. Lease L does not contain a bargain-purchase option. The lease term is equal to 80% of the estimated economic life of the equipment. economic life of the equipment. economic life of the equipment 2. Lease M contains a bargain-purchase option. The lease term is equal to 50% of the estimated 3. Lease N does not contain a bargain-purchase option. The lease term is equal to 50% of the estimated Instructions (a) How should Santiago Company classify each of the three leases above, and why? Discuss the ra- (b) What amount, if any, should Santiago record as a liability at the inception of the lease for each of the (c) Assuming that the minimum lease payments are made on a straight-line basis, how should Santiago (AICPA adapted) tionale for vour answer three leases above? record each minimum lease payment for each of the three leases above?

Explanation / Answer

(a) Lease L should be classified as a capital lease because the lease term is equal to 80 percent of the estimated economic life of the equipment, which exceeds the 75 percent or more criterion.
Lease M should be classified as a capital lease because the lease contains a bargain-purchase option.
Lease N should be classified as an operating lease because it does not meet any of the four criteria for classifying a lease as a capital lease.

(b) For Lease L, Santiago Company should record as a liability at the inception of the lease for an amount equal to the present value at the beginning of the lease term of the minimum lease payments during the lease term. This amount excludes that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon. However, if the amount so determined exceeds the fair value ofthe equipment at the inception of the lease, the amount recorded as a liability should be the fair value.
For Lease M, Santiago Company should record as a liability at the inception of the lease an amount determined in the same manner as for Lease L, and the payment called for in the bargain-purchase option should be included in the minimum lease payments at its present value.
For Lease N, Santiago Company should not record a liability at the inception of the lease.

(c) For Lease L, Santiago Company should allocate each minimum lease payment between a reduction of the liability and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the liability.
For Lease M, Santiago Company should allocate each minimum lease payment in the same manner as for Lease L i.e. Santiago Company should allocate each minimum lease payment between a reduction of the liability and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the liability.
For Lease N, Santiago Company should charge minimum lease (rental) payments to rental expense as they become payable.

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