On January 1, 2020, Fern Corp. enters into an agreement with Nicki Rentals Inc. to lease a machine from them. Both corporations adhere to ASPE. The following data relate to the agreement:
1) The term of the non-cancellable lease is three years with no renewal option. Payments of $ 543,244 are due on December 31 of each year.
2) The fair value of the machine on January 1, 2020, is $ 1,400,000. The machine has a remaining economic life of 10 years, with no residual value. The machine reverts to the lessor upon the termination of the lease.
3) Fern depreciates all its machinery on a straight-line basis.
4) Fern's incremental borrowing rate is 10%. Fern does not have knowledge of the 8% implicit rate used by Nicki.
5) Immediately after signing the lease, Nicki discovers that Fern is the defendant in a lawsuit that is sufficiently material to make collectibility of future lease payments doubtful.
From Fern's viewpoint, what type of lease is this?
A) operating lease
B) finance lease
C) manufacturer or dealer lease
D) other finance lease

Question

Quizplus · Accepted Answer

This is a finance lease because:
- The lease term covers a major part of the economic life of the machine (3 years out of 10).
- The present value of lease payments is substantially equal to the fair value of the machine ($1,400,000).
- The machine reverts to the lessor upon the termination of the lease.
Fern must initially recognize the machine as a leased asset at its fair value of $1,400,000, and record a lease liability for the present value of the lease payments of $1,400,000. Fern's incremental borrowing rate is used to discount the lease payments, since the implicit rate is not known. 
However, the collectibility of future lease payments is doubtful due to the lawsuit, and therefore Fern must assess whether a provision for impairment is necessary.