An Example To Illustrate How To Classify A Lease As Finance Lease

Below example demonstrate how to classify a lease into a finance lease:

Question:

ABC Ltd enters a lease agreement on 1 January 2009 to have the right to use the asset for 10 years. The economic life of the asset is 11 years. The fair value of the asset is $12 million. The lessee agreed to pay $1.6 million annually for 10 years at the beginning of each year. The present value of the minimum lease payment is $10.5 million.

Required:How should the lease be classified?

Answer:

On the inception date 1 January 2009,the lease will be classified as a finance lease due to:

• the lease period is 10 years,which is 91% of the economiclife of the asset. Therefore it meets the criteria being the lease forms the major part of the economic life of the assets,even if its title is not transferred
• the present value of the minimum lease period is substantially all (87.5%) of the fair value of the asset

The asset will be depreciated over 10 years.

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