The lease agreement allows Rick's Pawn Shop to lease the truck for six years, with an option to extend for three years. The annual lease payments are $29,000, calculated using a 7% discount rate. The truck's expected useful life is nine years, and its fair value is $217,500. Rick's made significant improvements to the truck at the beginning of the third year, creating an expectation of extending the lease, which is "reasonably certain." The relevant interest rate at that time was 8%.
At the beginning of the lease, on January 1, 2024, Rick's had no significant economic incentive to exercise the three-year extension option. This means that Rick's did not have a strong reason or benefit to extend the lease for an additional three years.
The truck has an expected useful life of nine years and a fair value of $217,500. These details give us an idea of the truck's lifespan and its market value.
However, on January 1, 2026, at the beginning of the third year of the lease, Rick's made significant improvements to the truck. These improvements can only be recovered if Rick's exercises the extension option. As a result, there is now an expectation that the lease will be extended for three years, and this expectation is "reasonably certain." This means that it is highly likely that the lease will be extended because of the significant improvements made to the truck.
Additionally, the relevant interest rate at that time, January 1, 2026, was 8%. This interest rate is important because it affects the calculations and considerations related to the lease extension.