Question

Corinth Co. leased non-specialized equipment to Athens Corporation for an eight-year period, at which time possession of the equipment will revert back to Corinth. The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the lease payments for both the lessor and lessee is $20.6 million. The first payment was made at the beginning of the lease. How should Corinth classify this lease?

My teacher gives the below answer:

The present value of the lease payments is greater than “substantially all” of the fair value of the asset ($20.6 / $22.4 = 92%). The criteria indicate it is a sales-type lease to Corinth. Furthermore, it’s a sales-type lease with a selling profit because the present value of the lease payments ($20.6 million) exceeds the lessor’s cost ($16 million).

I don't understand why we should use $22.4 as the fair value, not the $16 carrying at cost.

Answer 1

First you need to understand what was need to classify lease or what was the need to make provision for classification :

Companies earlier used to take assets on lease with the intention to purchase but used to show it like a rent and debit rent amount in the profit and loss account for tax manipulation then , provision related to classification was introduced.

Lease can be categorized in two categories

Finance ( Actual Intention is to purchase the asset )

Operating ( asset is here taken on rent)

Talking about finance lease

According to that provision one of the condition is present value of lease rental and salvage value should be equal to or greater than fair value of assets in order to categorized lease as a finance lease..

Now, answer to your question

Suppose , you want to buy an asset will you pay someone it's carrying value or actual market value and will seller sell asset at carrying price or it's actual market price the answer is actual market price or fair value. Similarly here, we consider fair value of asset. The reason behind this provision is that the person who is taking asset on lease is actually purchasing an asset and the payment of lease rentals is actually the fair value of asset.

This question can also be solve in one other way also, the lease period covers major portion of useful life of asset that is 8 years / 12 years = 66.66 % ( more than 50 % which means major portion) so, intention is to purchase the asset.

Only thing you need to keep in mind is to check the intention of the person who is taking asset on lease as I have earlier explained through the background of this provision.