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altosal · Dec 9, 2010, 06:32 PM

Thomas Corporation leases a building from Smith Corporation for 10 years for $50,000 at the end of each year and pay $10,000 for maintenance per year. The building has a fair value of $350,000 and a useful life of 25 years. Thomas can finance this lease at a 12% interest rate. The lessor's implicit interest rate is 10%. The Thomas lease is an operating lease because the asset reverts to the lessor or the lease value is less than 90% of the fair value?

I chose the latter.

Just Looking · Dec 10, 2010, 03:13 PM

Is this the way the question was written in your text? It seems confusing to me. There are four criteria to examine to see if this is a capital lease. If any of the four are met, it is a capital lease. One of those is whether the asset reverts to the lessor or becomes the property of the lessee. Another is whether the present value of the rent is greater than 90% of the fair value of the asset. It seems to me that both of the choices you have would indicate an operating lease, and the other 2 criterion (length of lease less than 75% of useful life and a bargain purchase price) lead to an operating lease.

altosal · Dec 10, 2010, 05:15 PM

Thomas Corporation leased a building from Smith Corporation for 10 years for $50,000 to be paid at the end of each year. The building has a fair value of $350,000 and an estimated useful life of 25 years. In addition to the lease payments, Thomas will pay $10,000 per year for maintenance. Thomas can finance the lease with a bank at a 12% rate. The lessor's implicit interest rate is 10%. The Thomas lease is a/an:

Just Looking · Dec 11, 2010, 12:43 PM

If #3 is the entire question, they are looking for an answer of operating or capital lease. You've already indicated that the none of the 4 criteria are met to call it a capital lease.

altosal · Dec 11, 2010, 05:33 PM

Is it an operationg lease because it reverts to the lessor or because the lease value is less than 90% of the fair value?
Please let me know if I'm understanding this correctly.

Just Looking · Dec 11, 2010, 05:48 PM

Leases are capital leases if any one of four conditions exist:

1. There is an ownership transfer to the lessee at the end of the lease. In your example, there is no transfer.

2. The purchase option is a bargain option. (a common one was that the lessee could purchase the asset for $1 at the end of the term) There is no bargain option in your example.

3. The lease term is at least 75% of the useful life. Your example is not (10/25).

4. The present value of the lease payments is greater than 90% of the FMV of the asset at the beginning of the lease. Your example is not.

Because none of the 4 criteria are met, it is an operating lease. It is not either/or of those answers in your original question. Both have to exist. That is why I asked you for the actual question. Did your actual question give you multiple choices, or is it open-ended as written in your second post. If open-ended, I would answer that it is an operating lease - and if you have to answer why, you go through the 4 criteria for capital leases and show that none are met.

That's what is confusing about your question.