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

(c) Assuming that the minimum lease payments are made on a straight-line basis, how should Santiago record each minimum lease payment for each of the three leases above?

Short answer

Answer

Minimum lease payment should be recorded for L and M between a reduction of the liability and interest expense and for N rental expense as they become payable.

Step-by-step solution

Meaning of Straight-line basis

Straight-line" approaches allow expenditures to be dispersed equally across a set period of time. Straight-line depreciation indicates that an asset's value drops gradually during its useful life, rather than unevenly as in a bell-curve type model.

Explaining how Santiago should record each lease payments

For Lease L, Santiago Company should divide each minimum lease payment between liability reduction and interest expenditure, resulting in a constant monthly rate of interest on the obligation's remaining balance.

Santiago Company should assign each minimum lease payment in the same way that it did for Lease L for Lease M.

Santiago Company shall charge minimum lease (rental) payments when they become due to rental expenditure for Lease N.