A lease with a three-year term calls for a $5,000 payment at the end of each of those years.The three payments are the only ones required in the lease.The residual value at the end of the lease term is not guaranteed.The asset reverts to the lessor at the end of the term.The lessee has no way of knowing the unguaranteed residual value at the end of the lease term, or the one at the end of the asset's useful life, or the total useful life of the asset at inception.However, the lessee does know the lessor's implicit rate (10%), and the asset's fair market value at inception ($14,000).The lessee's borrowing rate on similar debt is 8%.Therefore:
A)lessee has a finance lease as the lease term is at least 75% of the asset's remaining life at inception.
B)lessee has an operating lease as none of the four criteria are fulfilled.
C)lessee has a finance lease as the present value of lessee minimum lease payments exceeds 90% of the asset's fair market value at inception.
D)lessee has an operating lease as the present value of lessee minimum lease payments is less than 90% of the asset's fair market value at inception
E)the 90% criterion does not apply in this case

Question

Quizplus · Accepted Answer

The present value of the lease payments can be calculated using the lessor's implicit rate of 10% because it is known to the lessee and is likely lower than the lessee's incremental borrowing rate. Calculating the present value of $5,000 payments for three years at a 10% discount rate exceeds 90% of the asset's fair market value at inception ($14,000), thus meeting one of the criteria for a finance lease.

A Lease with a Three-Year Term Calls for a $5,000