Question

The Deluxe Corporation has just signed a 168-month lease on an asset with a 19-year life. The minimum lease payments are \(1,300 per month (\)15,600 per year) and are to be discounted back to the present at a 9 percent annual discount rate. The estimated fair value of the property is $165,000.

c. Should the lease be recorded as a capital lease or an operating lease? Use criteria 3 and 4 for a capital lease.

Short answer

The lease should be recorded as an operating lease.

Step-by-step solution

Information available

Time of lease = 168 month

Life of asset = 19 years

Minimum monthly payments = $1,300

Minimum annual payments = $15,600

Discount rate = 9%

Estimated fair value of asset = $165,000

Lease term as a percentage of the asset’s life = 73.69%

Present value of lease payments as a percentage of asset’s fair value = 73.6%

3rd and 4th criteria of lease classification

The 3^rd criterion requires that the lease term be equal to or more than 75% of the life of the asset for the lease to be classified as a capital lease. Since the lease term is less than 75%, this criterion is not fulfilled.

As per the 4^th criterion, the minimum lease payments to be made should be equal to or more than 90% of the fair value of the asset to classify a lease as a capital lease. Asset's fair value. The present value of the lease payments is equal to 73.6% of the asset’s fair value; this criterion is also not satisfied.

Therefore, the lease will be classified as an operating lease.