On January 1, 2020, Dionne Ltd. signs a 10-year non-cancellable lease agreement to lease a storage building from Seline Inc. Seline is in the business of leasing/selling property. Collectibility of the lease payments is reasonably assured and no additional costs are to be incurred by the lessor (other than executory costs). Both the lessor and the lessee are private corporations adhering to ASPE. The following information is available regarding this lease agreement:
1) The agreement requires equal payments at the end of each year.
2) At January 1, 2020, the fair value of the building is $ 900,000 and Seline's book value is $ 750,000.
3) The building has an estimated economic life of 10 years, with no residual value. Dionne uses straight-line depreciation for all its depreciable assets.
4) At the termination of the lease, title to the building will transfer to the lessee.
5) Dionne's incremental borrowing rate is 11%. Seline Inc. set the annual rental to ensure a 10% rate of return. The lessor's implicit rate is known to Dionne.
6) The yearly lease payment includes $ 3,000 executory costs related to taxes on the property.
From the lessee's viewpoint, what type of lease is this?

Question

Quizplus · Accepted Answer

Based on the information provided, this lease should be classified as a capital lease for Dionne Ltd. This is because it meets the criteria for capital leases established by ASPE:

1) The lease term is equal to the economic life of the asset.
2) The present value of the lease payments at the beginning of the lease term exceeds 90% of the fair value of the asset.
3) Ownership of the asset transfers to the lessee at the end of the lease term.

Additionally, the fact that Seline set the annual rental to ensure a 10% rate of return indicates that Seline has transferred substantially all the risks and rewards of ownership to Dionne. As a result, Dionne should record the leased asset on its balance sheet at the beginning of the lease term at the fair value of the building ($900,000). The present value of the lease payments should be recorded as a liability on the balance sheet, and the lease payments should be apportioned between interest expense and reduction of the lease liability following the effective interest method. Finally, the straight-line depreciation method should be applied to the leased asset over the lease term.