Question

Flanigans Company leases a building to Wellington, Inc. on January 1,2025 . The following facts pertain to the lease agreement.

1. The lease term is 6 years, with equal annual rental payments of $7,652 at the beginning of each year.
2. Ownership does not transfer at the end of the lease term, there is no bargain purchase option, and the asset is not of a specialized nature.
3. The building has a fair value of $42,000, a book value to Flanigans of $37,000, and a useful life of 7 years.
4. At the end of the lease term, Flanigans and Wellington expect there to be an unguaranteed residual value of $3,000.
5. Flanigans wants to earn a return of 6% on the lease, and collectibility of the payments is probable. Wellington was unaware o the implicit rate used in the lease by Flanigans and has an incremental borrowing rate of 8%.
How would Flanigans (lessor) and Wellington (lessee) classify this lease? Flanigans would classify the lease as a lease.

Answer 1

Flanigans Company would likely classify the lease as an operating lease, as it does not involve a transfer of ownership, a bargain purchase option, or a specialized asset, and the term is shorter than the asset's useful life.

Step-by-step explanation:

When determining how Flanigans Company (lessor) and Wellington, Inc. (lessee) would classify a lease, the details of the lease agreement must be examined in the context of leasing standards. Considering the information provided:

• The lease does not transfer ownership or contain a bargain purchase option.
• The building is not specialized in nature.
• The lease term is shorter than the useful life of the building.
• Flanigans desires to earn a 6% return on the lease.

Since ownership does not transfer, there is no purchase option, and the asset is not specialized, this lease would likely be classified as an operating lease by both the lessor and the lessee. However, accounting standards may vary depending on the jurisdiction and should be consulted for final classification. It should also be noted that since Wellington was unaware of the implicit rate, it will likely use its own incremental borrowing rate for any accounting purposes.