Lease Inception

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SHAMS KAMAL
0832505

LEASE INC

MIDTERM

Abstract
Lessee Ltd., a British company that applies IFRSs, leased equipment from Lessor Inc. on January 1, 2007, for a period of three years. Lease payments of $100,000 are due to Lessor Inc. each year. Other expenses (e.g., insurance, taxes, and maintenance) are also to be paid by Lessee Ltd. and amount to $2,000 per year. The lessor did not incur any initial direct costs. The lease contains no purchase or renewal options and the equipment reverts back to Lessor Inc. on the expiration of the lease. The remaining useful life of the equipment is four years. The fair value of the equipment at lease inception is $265,000. Lessee Ltd. has guaranteed $20,000 as the residual value at the end of the lease term. The salvage value of the equipment is expected to be $2,000 after the end of its economic life. The lessee’s incremental borrowing rate is 11 percent (Lessor’s implicit rate is 10 percent and is calculable by the lessee from the lease agreement).

The junior accountant of Lessee Ltd. analyzed the assets under lease and prepared a computation. The senior accountant of Lessee Ltd. reviewed the analysis and the computation and prepared a separate analysis.

Criteria 1
Was the junior accountant’s analysis correct? Yes

Junior accountant has chosen to present the lease as the operating lease since the equipment reverts back to Lessor Inc.

If we ignore the fact that he has done a classification error by not identifying it as a finance lease, everything that has to be done for an operating lease is correct.

Dr. Lease expense | $100,000 |
Dr. Insurance expense | $2,000 |
Cr. Cash | $102,000 |

The journals for this entry are completely right. The treatment used is correct.

Was the junior accountant’s analysis correct? NO

Junior accountant has chosen to present the lease as the operating lease since the equipment reverts back to Lessor Inc.

But the junior accountant has done a major classification error by not presenting it as finance lease.

According to ASC 840-10-25-1   
“A lessee and a lessor shall consider whether a lease meets any of the following four criteria as part of classifying the lease at its inception under the guidance in the Lessees Subsection of this Section (for the lessee) and the Lessors Subsection of this Section (for the lessor): * a. Transfer of ownership. The lease transfers ownership of the property to the lessee by the end of the lease term. This criterion is met in situations in which the lease agreement provides for the transfer of title at or shortly after the end of the lease term in exchange for the payment of a nominal fee, for example, the minimum required by statutory regulation to transfer title. * b.  Bargain purchase option. The lease contains a bargain purchase option. * c. Lease term. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease. * d. Minimum lease payments. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor. If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease. “...
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