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Lease Agreements: Factors as a Capital or Operating Lease

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The XYZ Company entered into the following leasing arrangements, as the lessee, during the current year:

A. XYZ leased a copy machine for 3 years. The fair market value of the machine at the inception of the lease was $17,500 and XYZ agreed to pay a quarterly lease payment of $1,475. At the end of the lease the remaining life is estimated to be 2 years and XYZ has the option to purchase the copy machine for its then estimated fair market value of $5,000.

B. XYZ leased a mid-range computer for 4 years. The fair market value of the computer at the inception of the lease was $139,000 and XYZ agreed to pay a quarterly lease payment of $9,000. At the end of the lease the remaining life is estimated to be 2 years. XYZ has no option to purchase the computer at any time during the lease term.

C. XYZ leased a new car for 2 years for its president's use. The fair market value of the car at the inception of the lease was $65,000 and XYZ agreed to pay a quarterly lease payment of $5,750. At the end of the lease the remaining life is estimated to be 4 years. XYZ has no option to purchase the car at any time during the lease term.

D. XYZ leased a delivery truck for 5 years. The fair market value of the truck at the inception of the lease was $84,000 and XYZ agreed to pay a quarterly lease payment of $4,500. At the end of the lease the fair market value of the truck is estimated to be $24,000 and the truck's remaining economic life is estimated to be 2 years. XYZ has the option to purchase the truck at the end of the lease for $10,000.

E. XYZ leased a collation machine for 6 years. The fair market value of the machine at the inception of the lease was $142,000 and XYZ agreed to pay a quarterly lease payment of $6,750. At the end of the lease, the ownership of the machine transfers to XYZ.

F. XYZ leased a widget production machine for 7 years. The fair market value of the machine at the inception of the lease was $246,000 and XYZ agreed to pay a quarterly lease payment of $11,000. XYZ has no option to purchase the machine at any time during the lease term.

XYZ current borrowing rate is 10%.

All lease payments are made in advance at the beginning of each quarter.

Instructions:

1) Determine if each lease is an operating or a capital lease.

2) For each capital lease, identify the factor or factors that qualify the lease as a capital lease. Include the appropriate calculations to support your conclusions.

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Solution Preview

A lease will be a capital lease if it meets any one of the following four criteria –
a. There is a bargain purchase option at the end of the lease
b. The lease transfers ownership at the end of the lease
c. The lease term is greater or equal to 75% of the economic life of the asset
d. The present value of lease payments is greater or equal to 90% of fair value of the asset.
We apply these criteria to see if the lease is a capital lease or an operating lease.

The XYZ Company entered into the following leasing arrangements, as the lessee, during the current year:

A. XYZ leased a copy machine for 3 years. The fair market value of the machine at the inception of the lease was $17,500 and XYZ agreed to pay a quarterly lease payment of $1,475. At the end of the lease the remaining life is estimated to be 2 years and XYZ has the option to purchase the copy machine for its then estimated fair market value of $5,000.

There is no bargain purchase option.
Lease life is 3/5 (at the end of lease there are still 2 years left and so asset life is 5 years)= 60% of asset life which is <75%
The PV of lease payments is 1,475 per quarter, quarter rate is 10%/4 = 2.5% and number of quarters are 3X4 =12. This is annuity due since the payments ...

Solution Summary

The solution explains how to classify a lease as capital or operating lease. For each capital lease, the factors that qualify the lease as a capital lease are identified.

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See Also This Related BrainMass Solution

Finance: Lease Agreement and Capital Budgeting

At the beginning of its accounting year Alice plc leases a machine from Louise Leasing plc. The following information relates to the lease agreement:
1. The term of the lease is 5 years, and the lease agreement is non-cancellable, requiring equal rental payments of £9,276 at the beginning of each year;
2. The machine has a fair value at the inception of the lease of £40,000, an estimated economic life of 5 years, and no residual value;
3. Alice plc's incremental borrowing rate is 10% per year;
4. Alice plc depreciates similar equipment that it owns on a straight-line basis;
5. Louise Leasing plc has set the annual rental to earn a rate of return on its investment of 8% per year; this fact is known to Alice plc.

Required:

(a) Should the above lease agreement be accounted for as a finance or an operating lease? Give reasons to justify your answer.

(b) Prepare the journal entries for Alice plc that relate to the above lease agreement during years 1 and 2 for each of the following assumptions:

(i) The lease is classified as a finance lease;

The actuarial method should be used to allocate finance charges to accounting periods during the lease term.

(ii) The lease is classified as an operating lease.

(c) With reference to (b) discuss the extent to which the distinction between a finance lease and an operating lease is important for financial reporting and analysis.

2-a) Describe the factors that should be taken into consideration by firms when forming their capital structure.

2-b) Describe the "Efficient Market Hypothesis" (EMH). Explain how the "Efficient Market Hypothesis" is used to explain the stock market behaviour.

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