Question

Alice Foyle, M.D. (lessee), has a noncancelable 20-year lease with Brownback Realty, Inc. (lessor) for the use of a medical building. Taxes, insurance, and maintenance are paid by the lessee in addition to the fixed annual payments, of which the present value is equal to the fair value of the leased property. At the end of the lease period, title becomes the lessee’s at a nominal price. Considering the terms of the lease described above, comment on the nature of the lease transaction and the accounting treatment that should be accorded it by the lessee.

Short answer

The nature of the lease is a capital lease.

Step-by-step solution

Meaning of Capital Lease

The transfer of ownership rights from one party to another at the completion of the lease periodis term as a capital lease. A lessee might benefit from capital leasing by purchasing an asset at a lower cost than the market value.

Explaining the nature of the lease

The lease agreement should be treated as a capital lease as it involves a bargain purchase option that transfers ownership of the asset to the lessee. The fact that the lessee gets all costs, as well as a reasonable rate of return on investment, demonstrates the capital lease's nature.

Assets and liabilities should be recorded at the discounted amount of future lease payments, which should be distributed between the land and the building in accordance with their fair values at the commencement of the lease, exactly like in a capital lease. The exemption should be based on the building's estimated useful life.