Question

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?

Short answer

Lease only pass the recovery of investment test.

Step-by-step solution

Meaning of Lease

A lease is a legally binding arrangement between a lessor and a lessee. This contract grants the lessee the right to utilize certain property owned by the lessor for a set length of time. The lessee pays the lessor rental payments over the lease period in exchange for the use of the property.

Explaining the classification of the lease

The lease fails the transfer of ownership, bargain purchase, and economic life tests [(5 years 8 years) <75%]. It does, however, satisfy the recovery of investment test. The present value of the minimum lease payments ($31,000 X 4.16986* = $129,266) exceeds 90% of the asset's FV (90 percent X $138,000 = $1categorizes a result, Callaway should categorize the lease as a capital lease.

Note: Present value of an annuity due of 1 for 5 periods at 10%.