Brief Exercise 21-1 (Essay) Callaway Golf Co. leases telecommunications equipmen

Question

Brief Exercise 21-1 (Essay) Callaway Golf Co. leases telecommunications equipment. Assume the following data for equipment leased from Photon Company. The lease term is 5 years and requires equal rental payments of $31,000 at the beginning of each year. The equipment has a fair value at the inception of the lease of $138,000, an estimated useful life of 8 years, and no residual value. Callaway pays all executory costs directly to third parties. Photon set the annual rental to earn a rate of return of 10%, and this fact is known to Callaway. The lease does not transfer title or contain a bargain-purchase option. How should Callaway classify this lease? LINK TO TEXT

Explanation / Answer

The lease does not meet the following tests:

-Ownership test

-Bargain Purchase test

-Economic life test[(5 years/8years)<75%].

But, the present value of minimum lease payments ($31,000*4.16986=$129266) is greater than 90% of the fair value of the asset(90%*138000=$124,200).

Therefore, Callaway should classify the lease as a capital lease.

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