Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281



Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281
Textbook Problem

Next Level Garvey Company (the lessee) entered into an equipment lease with Richie Company (the lessee) on January 1 of Year 1. Use the following information to decide whether this lease qualities as an operating or finance lease for Garvey, and give an explanation using the live classification criteria.

  1. 1. The equipment reverts back to the lessor at the end of the lease, and there is no bargain purchase option. The equipment is not specialized for Garvey.
  2. 2. The lease term is 5 years and requires Garvey to make annual payments of $65,949.37 at the end of each year.
  3. 3. The discount rate is 10%, which is implicit in the lease. Garvey knows this rate.
  4. 4. The fair value of the equipment at the lease inception is $250,000. The present value of an ordinary annuity of live payments of $65,949.37 each at 10% is $250,000.
  5. 5. The equipment has an estimated economic life of 7 years and has zero residual value at the end of this time. Straight-line depreciation is used for similar assets.

To determine

Identify whether the given lease qualifies as a finance lease or operating lease for Company G.


Lease: Lease is a contractual agreement whereby the right to use an asset for a particular period of time is provided by the owner of the asset to the user of the asset. The owner, who possesses the asset, is termed as ‘Lessor’ and user, to whom the right is transferred to, is termed as ‘Lessee’.

Operating leases: In an operating lease lessor retains all ownership risks and responsibilities.

Finance leases: In finance lease all the ownership risks and responsibilities are transferred from the lessor to the lessee.

The criteria for defining the lease as finance lease or operating lease:

As per the notes issued by Financial Accounting Standard Board (FASB), the following are four criteria to determine is a lease is a capital lease or an operating lease:

    1. Transfer of ownership: The asset is transferred to lessee at the end of the lease period concerned.

    2. Purchase (bargain) option: The purchase option is exercisable when the purchase price is sufficiently lower than expected fair value.

    3. Economic life: The economic life of the lease period is 75% or more than the useful life of the asset.

    4. Value recovery: Present value of lease payments is greater or equal to 90% of the fair value.

If a particular lease fulfils any one of the above four criteria, then it is considered as finance lease. If a lease does not fulfil any of the above four criteria, it would be considered as operating lease...

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