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Question: (Lessee-Lessor Entries, Operating Lease) Cleveland Inc. leased a new crane to Abriendo Construction under a 5-year noncancelable contract starting January 1, 2017. Terms of the lease require payments of \(33,000 each January 1, starting January 1, 2017. Cleveland will pay insurance, taxes, and maintenance charges on the crane, which has an estimated life of 12 years, a fair value of \)240,000, and a cost to Cleveland of \(240,000. The estimated fair value of the crane is expected to be \)45,000 at the end of the lease term. No bargain-purchase or -renewal options are included in the contract. Both Cleveland and Abriendo adjust and close books annually at December 31. Collectibility of the lease payments is reasonably certain, and no uncertainties exist relative to unreimbursable lessor costs. Abriendo’s incremental borrowing rate is 10%, and Cleveland’s implicit interest rate of 9% is known to Abriendo.

Instructions

1. Identify the type of lease involved and give reasons for your classification. Discuss the accounting treatment that should be applied by both the lessee and the lessor.

Step by step solution

01

Meaning of Operating lease

A short-term lease or contract in which the lessee agrees to rent an asset from the lessor while the lessor retains ownership rights is known as an operating lease. In other words, an operating lease is one that lasts shorter than a year and in which the lessor always retains control of the leased asset. In addition, unlike capital leases, operating leases can be canceled.

02

 Explaining the type of lease and its accounting treatment

The lease is an operating lease for both the lessee and the lessor because:

1. it does not transfer ownership,
2. it does not include a bargain-purchase option,
3. it does not cover at least 75 percent of the crane's expected economic life

(5/12 = 42 percent), and

4. The present value of the lease payments is less than 90 percent of the leased crane's fair worth.

Annual Lease Payments	$33,000
PV of an annuity due at 9% for 5 years	4.23972
	$139,910.76

The value $139,910.76 is less than $216,000.00 (90% $240,000.00).

For a lease to be described as something other than an operating lease, at least one of the four conditions must be met.

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