Question

Question: Brecker Company leases an automobile with a fair value of \(10,906 from Emporia Motors, Inc., on the following terms:

1. Non-cancelable term of 50 months.
2. Rental of \)250 per month (at end of each month). (The present value at 1% per month is \(9,800.)
3. Estimated residual value after 50 months is \)1,180. (The present value at 1% per month is \(715.) Brecker Company guarantees the residual value of \)1,180.
4. Estimated economic life of the automobile is 60 months.
5. Brecker Company’s incremental borrowing rate is 12% a year (1% a month). It is impracticable to determine Emporia’s implicit rate.

Instructions

(a)What is the nature of this lease to Brecker Company?

Short answer

Answer

The lease is a financial lease.

Step-by-step solution

Meaning of Lease 

For lease rentals, a finance lease is one in which the lessor passes nearly all of the risks and rewardsof asset ownership to the lessee. To put it another way, it puts the lessee in the same position as if he or she had bought the asset.

Explaining the nature of the lease

This lease is a financing lease to Brecker, the lessee because the terms meet the following criteria:

1. The lease period is for the majority of the economic life of the leased asset (more than 75 percent); that is, the lease duration is 831/3 percent (50/60) of the economic life.
2. The present value of the minimum lease payments equals substantially all (more than 90%) of the leased asset's fair value; for example, the present value of $10,515 (see below) equals substantially all (96%) of the leased asset's fair value: