Question

Federated fabrications leased a tooling machine on January 1, 2021, for a three-year period ending December 31, 2023. The lease agreement specified annual payments of $37,000 beginning with the first payment at the beginning of the lease, and each December 31 through 2022. The company had the option to purchase the machine on December 30, 2023, for $46,000 when its fair value was expected to be $61,000, a sufficient difference that exercise seems reasonably certain. The machine's estimated useful life was six years with no salvage value. Federated was aware that the lessor's implicit rate of return was 11%.

1) As indicated in class many times, list and briefly explain the 5 criteria to determine if this is a finance lease.

2) Is this a financing lease? How many of the criteria does this lease meet (that you can identify based on the information provided)?

3) Bonus (3 Points): Calculate the amount Federated should record as a right-of-use asset and lease liability for this finance lease.

Answer 1

1) 5 Situations which would normally lead to lease being classified as a finance lease are :

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

b) The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised.

c) The lease term is for the major part of the economic life of the asset even if title is not transferred.

d) At the inception of the lease, present value of minimum lease payments amounts to at least substantially all of the fair value of the leased asset

e) The leased asset is of a specialised nature such that only the lessee can use it without major modifications being made.

2) Yes, this is a financial lease as it meets one of the above criteria i.e. Federated (Lessee) has the option to purchase the machine (asset) at a price ($46,000) which is substantially lower than its fair value at that time ($61,000). [Refer (b) above].

3) Given implicit rate of return - 11%

Asset leasing date - 1 Jan 2021

Lease payments date Lease Amount Present Value   

1 Jan 2021 $37,000 $37,000

31 Dec 2021 $37,000   $33,333 (37000 / 1.11)

31 Dec 2022 $37,000 $30,030 [37000 / (1.11)2]

Total    $100,363

Amount Paid on 31 Dec 2023 to acquire asset = $46,000

Its present value is [46000 / (1.11)3 ] = $33,635

Therefore the value at which Federated should record the asset is

Present value of lease payments + Present value of amount paid to acquire the asset in the end

$100,363 + $ 33,635

= $133,988