Case 13-5 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.
Required:
What criteria must be met by the lease in order that Doherty Company classify it as a capital lease?
What criteria must be met by the lease meet in order that Lambert Company classify it as a sales-type or direct financing lease?
Contrast a sales-type lease with a direct financing lease.
To determine the classification of a lease, certain criteria must be met. The criteria for classifying a lease as a capital lease by Doherty Company include:
1. Ownership Transfer: The lease agreement should contain a provision for the transfer of ownership of the leased asset to Doherty Company at the end of the lease term.
2. Bargain Purchase Option: The lease should provide Doherty Company with an option to purchase the leased asset at a price significantly lower than its fair market value.
3. Lease Term: The lease term should be a significant portion of the economic life of the leased asset. Generally, if the lease term is 75% or more of the asset's economic life, it is considered a capital lease.
4. Present Value: The present value of the minimum lease payments, discounted at an appropriate interest rate, should be equal to or exceed 90% of the fair market value of the leased asset.
Now, let's move on to the criteria for Lambert Company to classify the lease as a sales-type or direct financing lease:
1. Ability to Transfer Risks and Rewards: For Lambert Company to classify the lease as a sales-type or direct financing lease, the lease agreement should transfer substantially all the risks and rewards of ownership to Lambert Company.
2. Collectibility of Lease Payments: Lambert Company must be able to reasonably estimate the collectibility of the lease payments associated with the lease.
Next, let's contrast a sales-type lease with a direct financing lease:
Sales-Type Lease:
A sales-type lease is used when the lessor is primarily in the business of selling or leasing similar assets. In a sales-type lease, the lessor recognizes profit or loss upfront upon lease inception based on the fair value of the leased asset.
Direct Financing Lease:
A direct financing lease is used when the lessor is primarily in the business of providing financing and does not sell or lease similar assets. In a direct financing lease, the lessor does not recognize profit or loss upfront; instead, the lease receivable is recorded based on the present value of the lease payments.
In summary, the classification of a lease as a capital lease for Doherty Company and a sales-type or direct financing lease for Lambert Company depends on meeting specific criteria related to ownership transfer, option to purchase, lease term, present value, ability to transfer risks and rewards, and collectibility of lease payments.