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Lease Classifications

Lease Classifications

Doherty Company leased equipment from Lambert Company. The classification of the lease makes a difference in the amounts reflected on the balance sheet and income statement of both Doherty and Lambert.

a. What criteria must be met by the lease in order that Doherty Company classifies it as a capital lease?

b. What criteria must be met by the lease meet in order that Lambert Company classifies it as a sales-type or direct financing lease?

c. Contrast a sales-type lease with a direct financing lease.

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Lease Classifications

Doherty Company leased equipment from Lambert Company. The classification of the lease makes a difference in the amounts reflected on the balance sheet and income statement of both Doherty and Lambert.

a. What criteria must be met by the lease in order that Doherty Company classifies it as a capital lease?

Lessee (Doherty Company in this case) can classify lease in two ways:

1. Operating Lease
2. Capital Lease

A capital lease is a lease that, from the point of view of the lessee, transfers substantially all the benefits and risks incident to ownership of property to the lessee. A capital lease must meet at least one of four criteria (Group 1 criteria).

1. The lessee (Doherty Company in this case) takes ownership of the leased property by the time the lease terminates.

2. The lease contains a bargain purchase (sure to be purchased) option.
- This provision allows the lessee to purchase the property for a price that is significantly lower than its expected fair market value, so that the exercising of that option by the lessee is reasonably assured. For example, an option to purchase the property for a dollar at the end of the lease would qualify.

3. The lease term is equal to 75% or more of the estimated economic life of the leased property.

4. The present value of the minimum lease payments is equal to or more than 90% of the fair market ...

Solution Summary

The criteria that must be met by the lease in order to classify it as a capital lease or sales-type or direct financing lease are discussed. A sales-type lease is contrasted with a direct financing lease.

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