Lotsa Leases Ltd. (“Lotsa”) has entered a lease arrangement with Low Liquidity Ltd. (“Low”). Lotsa will provide Low with equipment having a fair market value of $2.2 million for a term of five years. Low must make lease payments having a $2.0 million present value and may purchase the equipment at its appraised fair market value plus 10%, at any time during the course of the lease. The collectibility of the lease payments is considered secure. The equipment has an estimated useful life of 7 years and will be returned to Lotsa at the end of the lease. Under the lease terms there are significant additional equipment costs which may be incurred and are the responsibility of Lotsa. Given U.S. GAAP reporting requirements, which of the following choices properly reflects the classification of the lease on the books of Lotsa and Low? Lotsa Low a. Capital Operating b. Capital Capital c. Operating Operating d. Operating Capital
B
Capital lease for lotsa because 75% of 7 years is greater than 5. Same for low, particularly since costs incurred are the responsbility of lotsa during the least. B
I thought either lessee or lessor can have a capital lease ? Can you explain why is it Capital lease for LOW (lessor) ??
The answer must be D. Lotsa has significant equipment cost, the lease is operating for him.
map1 is right, the answer is D (is this because the lessor has to take care of the equipment when the contract concludes??) here is the full answer Choice “d” is correct. Usually, both the lessor (Lotsa) and the Lessee (Low) will use the same method of accounting for the same lease. However, it is possible for the lessor to record an operating lease and the lessee to record a capital lease. This is a result of two additional “capital lease” criteria which a lessor must meet: the collectibility of the minimum lease payments must be reasonable predictable and; there are no significant uncertainties regarding unreimbursable costs which will be the responsibility of the lessor. If either of these two risks to the lessor’s cash flow exists, the lessor must record the lease as an operating lease. In this case, the lease meets the initial criteria for classification as a capital lease as the present value of the lease payments is greater than 90% of the equipment’s fair market value: $2.0 Million > $1.98 Million ($2.2 Million x 90%). As a result, the lesee (Low) will record the lease as a capital lease. The lessor (Lotsa), however, will record the lease as an operating lease as there are significant uncertainties regarding the amount of unreimbursable costs they will incur. These costs allow considerable risks to remain with the lessor despite otherwise meeting the capital lease requirements. Note that the other capital lease requirements are not met under the terms of the equipment lease. Ownership does not transfer to Low at the end of the lease term. Low does not have the option of purchasing the equipment at below its fair market value. The lease term does not exceed 75% of the equipments useful life (5-Year Lease / 7-Year Useful Life = 71.4%).
If one of the conditions for a lessee applies (75% of life, discount purchase option, transfer of ownership, or 90% of minimum lease payment NPV) then you have 1 more test to see if the lessor includes it as a capital lease. question is are the mlp’s reasonably likely (they are in this case) and is there uncertainty regarding unreimburable costs (there isn’t).
is this in level 2 material?..i’ve found they mention leases a bunch of times but never really get into it deeply. and i specifically remember the schweser saying you weren’t responsible (beyond the material etc.) for classifying operating vs. capital leases. i may be completely wrong… can someone cite the page #, schweser or CFA?? thanks!!
Lotsa is the lessor, Low is the lessee. For Low, the lease is capital (PV of lease payments is 90.91% of market value). For Lotsa, because of the significant equipment costs that can be incurred, the lease is clasified as an operating lease. Had the payments be reasonably ensured, and no supplementary costs for the lessor would have incurred, the lease would have been capital for Lotsa too.
map1, could you elaborate on the significant equipment costs that oculd be incurred? does it stem from the fact that lotsa needs to retire the equipment and the conclusion of the lease contract?
No. For a lessor, the lease is clasified as a capital lease if two more conditions occur: 1. Collectibility of the minimum lease payments is reasonably predictable 2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor (this condition is not complied with, qualifies the lease for Lotsa as operating) Both conditions HAVE to happen, or the lease is operating for the lessor.
Augh, I flipped who was lessee and lessor!!
http://www.analystforum.com/phorums/read.php?11,687134,687197#msg-687197 Here is a post I made earlier in the year for capital and operating leases, lessors and lessees. Might serve as a usefull review.
thanks, i see it now, it’s explicitly stated in the question :-F dunno how i missed it
Oh, and one more thing: a lease CANNOT BE ever ever, operating for lessee and capital for lessor. The lessor qualifies a lease as capital if one out of the 4 conditions (SNOB) occur, plus BOTH of the above 1 and 2. Therefore, for a lessee, implicitly the lease is capital (since at least one of the 4 conditions happens).
cool, thanks for the link i’m just finishing up stalla on leases… man that thing is so thorough for SS9… i don’t think i would’ve been able to comprehend anything without it
stalla is doing an amazing job with the questions, I’d say the question are better than Schweser.