Lessee Santi contracts for three leases of three machines for six months: lease

Question

Lessee Santi contracts for three leases of three machines for six months: lease A, lease B and Lease C. Each lease is non-cancelable and each machine reverts to the lessor at the end of the lease term. The first rental payment for each machine is paid at the inception of the lease, with the balance to be paid in equal amounts at the start of each of five quarters thereafter. The lessors agreed to pay the executory costs and included this amount in the lease rentals. For each of the machine the present value of the minimum lease payment is equal to 55% of the fair value of the machine. The following information is peculiar to each lease:

1. Lease A: it is agreed that at the time of the sixth payment, for an added bargain purchase option payment Lessee Santi can buy the property. The lease term is equal to 70% of the estimated economic life of the asset.

2. Lease B: does not give the lessee the option to buy the machine. The lease term is equal to 90% of the estimated economic life of the asset.

3. Lease C: does not give the lessee the option to buy the machine. The lease term is equal to 70% of the estimated economic life of the asset.

Required:

1. How should Santi classify each of the three leases above, and why? Discuss the rationale for your answer.

2. What amount, if any, should Santi record as a liability at the inception of the lease for each of the three leases above?

3. Assuming that the minimum lease payments are made on a straight-line basis, how should Santi record minimum lease payment for each of the three leases above?

Explanation / Answer

1. How should Santi classify each of the three leases above, and why.

Lease A is a financial lease because leasse have right to purchase the asset at the end of lease term

Lease B: Is also a financial lease while does not give the lessee the option to buy the machine. But the lease term is equal to 90% of the estimated economic life of the asset. therefore one condition of financial lease is stisfying here.

Lease C: Is a opereting lease because does not give the lessee the option to buy the machine. The lease term is equal to 70% of the estimated economic life of the asset

2.

Lease A - Finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments

Lease B - Finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments.

Lease C - Operating leases, the lease payments should be recognised as an expense in the income statement over the lease term on a straight-line basis

3.

Lease A - as interest and obligation payments

Lease B - as interest and obligation payments

Lease C - Under an operating lease, the lessee records rent expense (debit) over the lease term, and a credit to either cash or rent payable.

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