Phillips Corporation has entered into a monthly leasing contract for 3 years on
ID: 2800721 • Letter: P
Question
Phillips Corporation has entered into a monthly leasing contract for 3 years on an asset with a useful life of 5 years. The asset's estimated fair value is $28,000. The contract requires monthly lease payments of $850. There is no bargain purchase option or transfer of title in the lease contract. The discount rate is 9%. Should Phillips record this as a capital lease? Select one:
A. Yes, because the lease term makes this a capital lease.
B. No, because the lease contract contains no transfer of ownership.
C. Yes, because the lease payments make this a capital lease.
D. No, because this is an operating lease without a bargain purchase option.
Explanation / Answer
Whether Lease is Operatine Lease Following Conditions are Satisfied
1.The Life of the Lease Must not be Longer than 75% of the Life of Asset
2.The Lessor Cannot transfer Ownership of the asset to the Lessee at the end of Lease term.
3.There Cannot be Option to Purchase of asset at 'bargain Price' at the end of Lease term
4.The Present Value of the Lease Payment cannot exceed 90% of the Fair Market Value of Asset.
Checking Following Condition o Phillips Corporation
1.Phillips Corporation Lease Contract 3 Years ,Asset Useful Life is 5 Years
% of Lease compare to Life of Asset = 3Years /5 years = 60%
It is Less then 75% so First Condition are Satisfied.
2 Lease contract contains no transfer of ownership. Second Conditons satisfied
3.There is no bargain Purchase Option . Third Condition are Satisfied
4.Present Value of Lease Payment
PV of Lease Payment = 850*31.45(0.75(9% Year but Monthly is 0.75(9/12), For 36 month PV Factor is 31.45)
=26732.50
% Lease Payment = Present Value of Lease Payment /Fair Value of Asset
=26732.50/28000
=95.47%
Fourth Condition are not Satisfied because is Exceed 90% of Fair Value of Asset.
So Following Lease not Operating Lease.
Option D is Not correct
Option A and C also not Correct because it is not Capital Lease
Option B is Correct (i.e No,because the Lease contract contains no transfer of Ownership.