Textbook Problem

Types of Leases

On January 1, Hazard Company, a lessee, entered into three noncancelable leases for brand new general equipment: Lease J, Lease K, and Lease L. None of the three leases transfers ownership of the equipment to Hazard at the end of the lease term. For each of the three leases, the present value of the lease payments at the beginning of the lease term, excluding that portion of the payments representing executory costs, is 75% of the fair value of the equipment to the lessor at the inception of the lease. Each piece of equipment has an expected economic life of 5 years.

The following information is peculiar to each lease:

1. a. Lease J does not contain a bargain purchase option. The lease term is equal to 60% of the estimated economic life of the equipment.
2. b. Lease K contains a bargain purchase option. The lease term is equal to 60% of the estimated economic life of the equipment.
3. c. Lease L does not contain a bargain purchase option. The lease term is for 12 months.

Required:

1. 1. Explain how Hazard should classify each of the preceding three leases. Discuss the rationale for your answer.
2. 2. What amount, if any, should Hazard record as a liability at the inception of the lease for each of the preceding three leases?
3. 3. Assuming that the lease payments are made on a straight-line basis, how should Hazard record expense for each of the preceding three leases?