McCormick County agreed to acquire a new recreation equipment storage facility under a lease financing agreement. At the inception of the lease, a payment of $750,000 will be made; four additional annual lease payments, each in the amount of $750,000, are to be made at the end of each year, beginning late in the current year. The total amount to be paid under this lease is $3,750,000. The lease arrangements implied an annual interest rate of 6 percent. Therefore, the present value of the lease at inception, including the initial payment, is $3,348,829. Assume that the fair value of the building at the inception of the lease is $3,600,000. Was this lease properly classified as a capital lease?

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Ajax

11 January, 19:48

McCormick County agreed to acquire a new recreation equipment storage facility under a lease financing agreement. At the inception of the lease, a payment of $750,000 will be made; four additional annual lease payments, each in the amount of $750,000, are to be made at the end of each year, beginning late in the current year. The total amount to be paid under this lease is $3,750,000. The lease arrangements implied an annual interest rate of 6 percent. Therefore, the present value of the lease at inception, including the initial payment, is $3,348,829. Assume that the fair value of the building at the inception of the lease is $3,600,000. Was this lease properly classified as a capital lease?

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Harper Stevens · Answer 1

As uit meets two criterias it is correctly cassified as capital lease.

Explanation:

There are 4 criteria to determinate a capital lease

Transfer of Ownership Test

If the lease transfers ownership of the asset to the lessee, it is a finance lease.

In this case, McCormick acquire the recreation equipment so it is a financial lease.

Bargain-Purchase Option Test

A bargain-purchase option allows the lessee to purchase the leased property for a price.

In this case there is none.

Economic Life Test

If the lease exteend over 75% of the assets useful life

Probably the storage facility will last more than 5 years so this criteria is not meet.

Recovery of Investment Test

If the present value of the minimum lease payments equals or exceeds substantially all of the fair value of the asset, then it should capitalize the leased asset.

About 90% of the fair value is consedered it meets this criteria.

3,348,829 / 3,600,000 = 0,930 = 93%