Lessee Capitalization Criteria
Response to the following problem:
On January 1, Santiago Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Santiago at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, is 75% of the fair value of the equipment.
The following information is peculiar to each lease.
1. Lease L does not contain a bargain-purchase option. The lease term is equal to 80% of the estimated economic life of the equipment.
2. Lease M contains a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.
3. Lease N does not contain a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment.
Instructions
(a) How should Santiago Company classify each of the three leases above, and why? Discuss the rationale for your answer.
(b) What amount, if any, should Santiago record as a liability at the inception of the lease for each of the three leases above?
(c) Assuming that the minimum lease payments are made on a straight-line basis, how should Santiago record each minimum lease payment for each of the three leases above?