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

(b) What amount, if any, should Santiago record as a liability at the inception of the lease for each of the three leases above?

Short answer

Answer

Santiago Company should record as a liability at the inception of the lease only for leases L and M.

Step-by-step solution

 Meaning of Lease Capital 

A capital lease is one in which the lessor simply funds the leased asset, and the lessee retains all other ownership rights. As a result, the item is recorded as the lessee's property in the lessee's general ledger as a fixed asset.

Explaining the amount that Santiago should record as a liability at the inception of the lease for each of the three leases above.

For Lease L, Santiago Company should record an amount equal to the present value at the beginning of the lease period of the minimum lease payments during the lease duration as a liability at the lease's initiation. This figure eliminates the percentage of the payments that represent the lessor's executory costs, such as insurance, maintenance, and taxes, as well as any profit earned. If the sum so calculated exceeds the fair value of the equipment at the start of the lease, the fair value should be recorded as a liability.

For Lease M, Santiago Company should record an amount computed in the same way as Lease L as a liability at the lease's beginning, and the payment required under the bargain-purchase option should be included in the minimum lease payments at its current value.

For Lease N, Santiago Company should not record a liability at the inception of the lease.