Question

(Lessee-Lessor Accounting for Residual Values) Goring Dairy leases its milking equipment from King Finance Company under the following lease terms.

1. The lease term is 10 years, noncancelable, and requires equal rental payments of \(30,300 due at the beginning of each year starting January 1, 2017.
2. The equipment has a fair value and cost at the inception of the lease (January 1, 2017) of \)220,404, an estimated economic life of 10 years, and a residual value (which is guaranteed by Goring Dairy) of $20,000.
3. The lease contains no renewable options, and the equipment reverts to King Finance Company upon termination of the lease.
4. Goring Dairy’s incremental borrowing rate is 9% per year. The implicit rate is also 9%.
5. Goring Dairy depreciates similar equipment that it owns on a straight-line basis.
6. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor.

Instructions

(a) Evaluate the criteria for classification of the lease, and describe the nature of the lease. In general, discuss how the lessee and lessor should account for the lease transaction.

Short answer

For the lessor, it is a direct financing lease.

For the lessee, it is a capital lease

Step-by-step solution

Meaning of lease

A lease is a bilateral agreement entered into by two persons, one who has possession of the property and the other who has the right to use the leased property for a specific period and amount.

Evaluating the criteria for the classification of the lease and describing the nature of the lease.

The lease agreement meets the requirements for 75 percent useful life and 90 percent fair value, collectability is generally predictable, and there are no significant uncertainties regarding the lessor's future expenses. It is a capital lease for the lessee and a direct-financing lease for the lessor (since cost equals fair value).