On 1/1/2013, Torrance Company began renting a fleet of snow-blowers from Crother

Question

On 1/1/2013, Torrance Company began renting a fleet of snow-blowers from Crothers, Inc. under a 6-year lease contract. The contract did not transfer title of the equipment from Crothers to Torrance and did not contain a bargain purchase option. The useful life of the equipment was estimated at 10 years on 1/1/2013, and the present value of lease payments were 50% of the fair value of the equipment on that date. On 1/1/2016, due to the effects of several harsh winters, both companies re-estimate the total useful life of the equipment to be only 7 years (from 1/1/2013 to 1/1/2020).

(a) How did the companies originally classify the lease for lease accounting purposes? (b) On 1/1/2016, should each company change the classification of the lease based on the new information?

Explanation / Answer

a) The company has classified it as an operating lease. Operating lease is a lease whose term is short compared to the useful life of the asset being leased. An operating lease is commonly used to acquire equipment on a relatively short-term basis. It does not have option bargain purchase option and the ownership is of lessor. It is used for less than 75% of the useful life of the asset for 6 years out of 10 years it is 60% so less than 75%.

b) Yes the comapny can change the classification as Finance lease as the useful life is 7 yeras and the lease term is 6 years, so almost whole of the asset is used by the lessor, To be a finance lease the criterio that the life of the lease is 75% or greater of the assets useful life should be achived. So the lease term is 6 out of 7 yeras so it is more than 75%

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