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Lease Agreements: Factors as a Capital or 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.

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.

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.

$2.19