(b) The fair value of the equipment is $75,000. The present value of the lease payments is $67,000 (excluding any executory costs)

Atwater Manufacturing Co. leases its equipment from Westside Leasing Company. In each of the following cases, assuming none of the other criteria for capitalizing leases are met, determine whether the lease would be a capital lease or an operating lease under FASB Statement No. 13. Your decision is to be based only on the terms presented, considering each case independently of the others.

(a) At the end of the lease term, the market value of the equipment is expected to be $20,000. Atwater has the option of purchasing it for $5,000.

(b) The fair value of the equipment is $75,000. The present value of the lease payments is $67,000 (excluding any executory costs).

(c) Ownership of the property automatically passes to Atwater at the end of the lease term.

(d) The economic life of the equipment is 12 years. The lease term is eight years.

(e) The lease requires payments of $9,000 per year in advance plus executor costs of $500 per year. The lease period is three years, and Atwater’s incremental borrowing rate is 12%. The fair value of the equipment is $28,000.

(f) The lease requires payments of $6,000 per year in advance, which includes executory costs of $500 per year. The lease period is three years, and Atwater’s incremental borrowing rate is 10%. The fair value of the equipment is $16,650.

SOLUTION

(a) Capital lease Contains a bargain purchase option.

(b) Operating lease $67,000 present value of lease payments divided by $75,000 fair value of equipment = 89%. This is less than the 90% cutoff, so it is an operating lease.

(c) Capital lease Ownership transfers to lessee at end of lease term.

(d) Operating lease An 8-year lease period divided by 12-year economic life = 67%. This is below the 75% cutoff for lease term, so it is an operating lease.

(e) Operating lease Present value of lease payments is $24,211*; $24,211/$28,000 = 86.5%. This is less than the 90% cutoff, so it is an operating lease.