Question

On January 1, 20X1, Draper Inc. signed a five-year noncancelable lease with Thornhill Company for custom-made equipment. The lease calls for five payments of $161,364.70 to be made at the beginning of each year. The leased asset has a fair value of $900,000 on January 1, 20X1. There is no bargain purchase option, and ownership of the leased asset reverts to Thornhill at the lease end. The leased asset has an expected useful life of six years, and Draper uses straight-line depreciation for financial reporting purposes. Its incremental borrowing rate is 8%. Draper uses a calendar year for financial reporting purposes.

Required:
1. Under U.S GAAP would Draper classify this lease as a capital lease or as an operating lease? Explain.
2. Under IFRS would Draper classify this lease as a capital lease or as an operating lease? Explain.

Answer 1

1. Under U.S GAAP the lease will be capital lease

2. Under IFRS it is leased under capital lease method.

Step-by-step explanation:

1. In order to determine Under U.S GAAP if Draper classify this lease as a capital lease or as an operating lease we would to calculate the lease payable as follows:

lease payable=(Annual Payment*present value after interest and tax)/Fair value

lease payable=($161,364.70*800)/$900,000

lease payable=77.3%

Under U.S GAAP the lease will be capital lease because the lease term is for 5 years was more than 75% of economic life

2. Under IFRS the assets are mostly considered by its economic value, so it is leased under capital lease method.