Question

Keller Corporation (the lessee) entered into a general equipment lease with Dallo Company (the les-sor) on January 1 of Year 1. Use the following information to decide whether this lease qualifies as an operating or finance lease for Keller, and give an explanation using the five classification criteria.

1. The equipment reverts back to the lessor at the end of the lease, and there is no bargain purchase option.

2. The lease term is 8 years and requires annual payments of $10,000 at the beginning of each year.

3. The fair value of the equipment at lease inception is $100,000. Assume that the present value of lease payments discounted at a 10% interest rate is $58,684.19.

4. The equipment has an estimated economic life of 20 years and has zero residual value at the end of this time.

Answer 1

A lease that meets one or more of the criteria mentioned below is classified as a finance lease. Otherwise, the same would be classified as an operating lease.

a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

In the given case, it has been specifically mentioned that the asset reverts back to the lessor at the end of the lease.
Hence, this condition is not satisfied.

b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

In the given case, it has been specifically mentioned that their is no bargain purchase option available. Hence, this condition is also not satisfied.

c. The lease term is for the major part of the remaining economic life of the underlying asset.

In the given case, the lease term (8 years) does not cover a major portion of the life of the asset (20 years). Hence, this condition is also not satisfied.

d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset.

In the given case, the present value of the sum of the lease payments ($ 58,684) does not cover the fair value of the asset ($ 100,000). Hence, this condition is also not satisfied.

e. The leased assets are of a specialized nature such that only the lessee can use them without significant modification.

No specific detail has been given in the question regarding this criteria. Hence, on the basis of previous 4 criterion, we assume that this criteria will also not be fulfilled.

Hence, the lease would be classified as an OPERATING LEASE as none of the 5 criterion have been satisfied.