Question

Corinth Co. leased equipment to Athens Corporation for an eight-year period, at which time possession of the leased asset will revert back to Corinth. The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the minimum lease payments for both the lessor and lessee is $20.4 million. The first payment was made at the inception of the lease. Collectibility of the remaining lease payments is reasonably assured, and Corinth has no material cost uncertainties. How should Athens classify this lease? Why?

Answer 1

Finance lease is as a lease agreement which transfers all the benefits and risks of ownership of the leased asset. A lease is considered as financial lease if it has following characteristics:

It transfers ownership of the asset to the lessee.

It permits the lessee to purchase the asset at the end of the lease period.

Lease term is at least 75% of useful life of the asset.

Present value of lease payment is at least 90% of the fair value of the asset.

The present value of the minimum lease payments ($20.6 million) is greater than 90% of the fair value of the asset $20.16 million (90% x $22 4 million). The lease period is for 8 years which is less than 75% of expected useful life. But, as one condition is met, the lease will be classified as finance lease. Furthermore, it is a sales-type lease with selling profit because the present value of the minimum lease payments($20.6 million) exceeds the lessors cost ($16 million).