On May 1, 2017 Mooney Leasing Company entered into a non-cancellable lease agree

Question

On May 1, 2017 Mooney Leasing Company entered into a non-cancellable lease agreement with Rode Company. The agreement requires Rode Company to make annual lease payments of $20,471.94 to Mooney Leasing Company annually on May, 1,2017 beginning on May 1, 2017 for equipment. Other information pertaining to this lease is below: 1. Bargain Purchase option price at end of lease: Lease Term: Economic life of asset: Lessor's cost to manufacture equipment Fair value of equipment at date of inception: Lessor's implicit rate: Lessee's implicit rate: The collectability of the lease payments is probably $4,000 5 years 10 years S65,000 $91,000 8% 8% a. What type of lease did these companies sign? Justify your answer by listing the 5 criteria and the Yes/No answers to every one of them.

Explanation / Answer

Criteria for determining the type of lease: Yes/No 1 The lease transfers the ownership of the asset to the lessee by the end of the lease term. No 2 Whether the lessee has the option to buy the asset at end of the lease term, for a price which is sufficently lower than Fair value at the date of option becomes exercisable such that, at the inception of lease, it is reasonably certain that the option will be exercised Yes 3 Whether the lease term is for the major part of the economic useful life of the asset. Yes 4.       If the Present value of lease payments, substantially equals the fair value of the asset. Not given 5 If the asset is of a specialized nature that only the lessee can use it without major modification. detail not given Notes: 1 The lease terms do not provide for automatic transfer of the ownership to Lessee 2 The agreement provides that lessee can purchase the asset at a bargain price, which is substantially lower than the FV of the asset at the date of option becomes exercisable, which is the end of lease term. 4 Fair value of the asset at the inception of lease, is not given. However, from the language it appears that the Present value of lease payments discounted at 8% would be equal to the FV of the asset. Solution: A lease is said to be a “Finance Lease (Capital Lease)” if it transfers to the lessee, substantially all the risk and reward in connection with the ownership of the asset. To determine this, the 5 criteria as listed above will help. These criteria whether individually or in combination, may provide that significant risks and rewards incidental to ownership of the asset is transferred to the lessee by the lessor. Though the points 4 & 5 are silent in this case, the critera 2 & 3 decisively help us classify the lease as "Capital Lease"

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