Example: Equipment Is Leased and Lease Does Not Transfer Ownership or Provide a Bargain Purchase Option Hawk Company (the lessee) and Dove Leasing Company (the lessor) sign a lease agree- ment dated January 1, 2016, in which Hawk leases equipment from Dove beginning January 1, 2016. The lease contains the terms and provisions shown in Example 20.2. EXAMPLE Terms and Provisions of Lease Agreement between Dove Leasing Company 20.2 (Lessor) and Hawk Company (Lessee) Dated January 1, 2016 1. The lease term is 4 years. The lease is noncancelable and requires equal payments of $32,923.45 at the end of each year. 2. The cost, and also fair value, of the equipment to Dove at the inception of the lease is $100,000. The equipment has an estimated economic life of 4 years and has a zero estimated residual value at the end of this time. 3. Hawk does not guarantee the residual value. 4. Hawk agrees to pay executory costs for maintenance of $4,000 per year directly on December 31 of each year. 5. The equipment reverts to Dove at the end of the 4 years; that is, the lease contains no transfer of ownership or bargain purchase option. 6. Hawk's incremental borrowing rate is 12.5% per year. 7. Hawk uses the straight-line method to record depreciation on similar equipment. 8. For Dove, the interest rate implicit in the lease is 12%. Hawk knows this rate. 9. The present value of an ordinary annuity of four payments of $32,923.45 each at 12% is $100,000 (3.037349 * $32,923.45).First, Hawk (the lessee) determines that the lease is a capital lease, as shown in Example 20.2a. EXAMPLE Application of Lease Classification Criteria by Hawk Company (Lessee) 20.2a Criteria Met? Remarks Capitalization Criteria 1. Transfer of ownership at No Title reverts to lessor end of lease 2. Bargain purchase option No 3. Lease term is 75% or more Yes 100% of estimated life of economic life 4. Present value of minimum Yes The present value is lease payments is 90% or $100,000, or 100% of more of fair value fair value Decision: A capital lease must meet one or more of the capitalization criteria; otherwise, the lease is an operating lease. Conclusion: The lease is a capital lease. It meets two of the four criteria.Because it is a capital lease, Hawk records the leased asset at the present value of the minimum lease payments using the 12% interest rate implicit in the lease. We assume that Hawk knows this rate, and the rate is lower than its incremental borrowing rate of 12.5%. Hawk also ensures that the capitalized amount does not exceed the fair value of the leased asset. Hawk pays the executory costs directly and expenses these costs as incurred. Hawk records the acquisition of the leased asset, the depreciation, and the annual payments for 2 years as follows: Initial Recording of Capital Lease on January 1, 2016 Leased Equipment 100,000.00 Capital Lease Obligation 100,000.00 Hawk records both the asset and the liability at the present value of the minimum lease payments ($100,000) rather than the nominal value of $131,693.80 (4 x $32,923.45)." First Annual Payment on Capital Lease on December 31, 2016 Interest Expense (12% x $100,000) 12,000.00 Capital Lease Obligation ($32,923.45 - $12,000) 20,923.45 Cash 32,923.45 The annual payment is comprised of both interest and principle. Note that this lease requires the payment to be made at the end of the year. Thus, the annuity is an ordinary annuity. If the lease requires the payments to be made at the beginning of the year, it is an annuity due (shown later in this chapter). The lessee depreciates the asset over the lease term because the lease does not include a transfer of ownership or a bargain purchase option. The lessee uses the straight-line method, and the annual depreciation is $25,000 ($100,000 + 4). The balance sheet of Hawk for December 31, 2016, includes the Leased Equipment minus the Accumulated Depreciation in the property, plant, and equipment section of its assets. It divides the Capital Lease Obligation between current liabilities and long- term liabilities, as we discuss in the next