Answer For Luv Company: Is It A Capital Lease?

Answerfor Luv Company It Is A Capital Lease The Following Tests Are

Answer for Luv company, it is a capital lease. The following tests are met: lease payments of $18,000, present value of annuity due at 10% for 5 years (PV factor = 4.16987), and a bargain-purchase option of $4,000. The present value (PV) of lease payments is calculated as $18,000 x 4.16987 = $75,058, which exceeds the fair value of the leased asset assumed at $70,000, indicating a capital lease. Additionally, the PV of lease payments is 107% of the fair value, surpassing the 75% threshold for the economic viability test. The lease term (5 years) is 100% of the economic life of the equipment, satisfying the economic test. The PV of the bargain purchase option is $2,484 (computed as $4,000 x 0.621, PV factor for 5 years at 10%). The lease's classification as a capital lease is confirmed by these criteria. The amortization schedule for Luv Company over the 5-year lease term will reflect initial lease liability of approximately $77,542, considering initial recognition of lease obligations plus any initial direct costs. The schedule will feature annual lease liability reductions and interest amortization based on the implicit interest rate of 10%, with interest expense computed as the opening balance multiplied by 10%, and principal repayment as the difference between the lease payment and interest expense.

Paper For Above instruction

In accordance with accounting standards, a lease transaction is classified as a capital lease when it meets certain criteria indicating the lessee effectively assumes the risks and rewards of ownership. For Luv Company, the lease is classified as a capital lease based on several qualifying tests, including the present value of lease payments exceeding 75% of the fair value of the leased asset, the lease term covering the entire economic life of the asset, and the existence of a bargain purchase option.

The calculation of the present value of lease payments is fundamental in establishing lease classification. The annual lease payment is $18,000, and with an implicit interest rate of 10%, the present value factor for five years is 4.16987. Multiplying these gives a total present value of approximately $75,058, which is higher than the asset's approximate fair value of $70,000. This indicates a significant economic interest and supports the classification as a capital lease. The inclusion of the bargain-purchase option further strengthens this classification because it provides the lessee an option to acquire the asset at a price below its expected fair value at the end of the lease term, which is consistent with the criteria for a capital lease.

The economic test requires that the lease term be at least 75% of the asset's useful life; here, the lease term is 100% of the asset's useful life, solidifying the lease's classification. The recovery test considers whether the PV of the lease payments exceeds 90% of the fair value, which it does in this case. Specifically, the PV of lease payments ($75,058) exceeds 90% of the fair value ($70,000), confirming the lease would meet this criterion.

Once classified as a capital lease, Luv Company must recognize a lease asset and liability on their balance sheet, commencing with the present value of lease payments and including any initial direct costs. Over the lease term, the company will amortize the leased asset systematically and recognize interest expense, following the effective interest method. The amortization schedule will show how lease liabilities decrease annually as portion of payments are allocated between interest and principal reduction.

The treatment of lease payments in financial statements impacts the company's debt ratios, asset base, and profitability. By capitalizing the lease, Luv Company enhances transparency regarding its obligations, aligning with the goal of providing a faithful representation of financial position and performance. Moreover, the presence of a bargain purchase option implies the company's intent and ability to gain ownership at minimal cost, justifying capital lease classification under accounting standards such as IFRS and GAAP.

Additionally, the classification impacts financial ratios such as debt-to-equity and return on assets, influencing investor perception and creditworthiness. The precise calculation and adherence to recognised criteria ensure that the lease is accurately reflected in financial statements, avoiding potential misstatements or misinterpretations of the company's financial health.

References

• FASB Accounting Standards Codification (ASC 842), Leases. Financial Accounting Standards Board. 2016.
• International Accounting Standard (IAS) 17, Leases, replaced by IFRS 16, Leases, effective from 2019.
• Choi, F., & Meek, G. K. (2011). International Accounting. Pearson Education.
• Bradshaw, M., & Miller, P. B. (2018). Financial Accounting: An International Introduction. Cengage Learning.
• Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2019). Financial Accounting Theory and Analysis. Wiley.
• U.S. Securities and Exchange Commission. (2020). Financial Reporting Manual. SEC.
• Erickson, M., & Rieley, J. G. (2008). Accounting Principles. Pearson Education.
• IASB. (2018). IFRS 16: Leases, International Financial Reporting Standards.
• Healy, P. M., & Palepu, K. G. (2012). Business Analysis & Valuation. Cengage Learning.
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