Question

Question: (Lessee Capitalization Criteria) On January 1, Santiago Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Santiago at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, is 75% of the fair value of the equipment.

The following information is peculiar to each lease.

1. Lease L does not contain a bargain-purchase option. The lease term is equal to 80% of the estimated economic life of the equipment.
2. Lease M contains a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.
3. Lease N does not contain a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.

Instructions

1. How should Santiago Company classify each of the three leases above, and why? Discuss the rationale for your answer.

Short answer

Answer

Lease L and M should be classified as a capital lease but lease M should be treated as an operating lease.

Step-by-step solution

Meaning of GAAP

GAAP is an acronym for "Generally Accepted Accounting Principles," which is a collection of accounting rules and industry practices that have been created over time. Organizations utilize it to appropriately arrange their financial data into accounting records, summaries the accounting data into financial statements, and reveal specific supporting data.

Explaining the classification of the three leases  

When a lease meets any one of the four requirements provided by GAAP for designating a lease as a capital lease, it effectively transfers practically all of the advantages and hazards associated with property ownership.

Lease L should be classed as a capital lease since the lease period exceeds the 75% or more criterion by 80% of the anticipated economic life of the equipment.

Since Lease M includes a bargain-purchase option, it should be categorized as a capital lease.

As Lease N does not match any of the four requirements for defining a lease as a capital lease, it should be classed as an operational lease.