Distinguishing between a rental and a financed purchase is difficult in practice
ID: 2572985 • Letter: D
Question
Distinguishing between a rental and a financed purchase is difficult in practice. Initially the FASB instituted bright line tests which firms then used to structure leases to get the accounting they wanted. Now the FASB says all leases are financed purchases. In either case we likely have errors why? Distinguishing between a rental and a financed purchase is difficult in practice. Initially the FASB instituted bright line tests which firms then used to structure leases to get the accounting they wanted. Now the FASB says all leases are financed purchases. In either case we likely have errors why?Explanation / Answer
Distinguishing between a rental and a financed purchase is really difficult in practice. FASB instituted bright line test for distinguishing between Rental and Financed purchase which includes whether the lease term is 75% or more of the economic life, and whether the present value of the rents is 90% or more of the fair value. This tests are helpful to some extent in finding the nature of lease. But practically some times this test also fails in finding the given nature of lease or it can be a mixed one thus making it difficult. Now if the FASB says that all leases are financed lease then also there will be errors as it may lead in misleading accounting for example, if the actual nature of lease is rental and we has treated it as financial.