Lessor Accounting for Finance Lease$-$Purchase Option

Company leases non$-$specialized equipment for $5$ years. The lease is noncancelable, and Morikawa agrees to pay $$50,000$ annually at the beginning of each year. Letlow Inc., the lessor, paid $$2,500$ in commissions to the salesperson at the inception of the lease. On November $1$ of each year, Morikawa pays property taxes of $$1,500$ and insurance of $$500.$

The cost of the equipment is $$185,000,$ and the fair value of the equipment is $$220,000.$ The equipment has an estimated useful life of $7$ years. The estimated residual value at the end of $5$ years is $$31,000$ and is not guaranteed by Morikawa. There is no bargain purchase option in the lease or any agreement to transfer ownership at the end of the lease to the lessee. The implicit interest rate is $12\%.$

Except that the estimated residual value of $$31,000$ is guaranteed by Morikawa. Morikawa believes it is probable that the payment under the residual value guarantee is $$15,000.$

The lease term is for $6$ years. Payments are due on December $31,$ beginning December $31,$ Year $1.$

The annual payment is set by Clark to earn a $6\%$ rate of return on its net investment. Lewis is aware of this rate. Lewis's incremental borrowing rate is $5\%.$

At the end of the $6-$year lease term, the machine is expected to betvorth $$40,000.$ This residual value is not guaranteed by the lessee or any other party.

The lease includes an option that allows Lewis to purchase the machine for $$23,500$ at the end of the lease term.

The estimated useful life of the machine is $7$ years.

Clark manufactured the machine at a cost of $$350,000.$

The collectability of all amounts due to the lessor is probable.

Required:

What is the proper classification of the lease for Clark $($the lessor$)?$

Criteria

Transfer of ownership at end of lease

Bargain purchase option

Lease term is for a major part of its economic life

Present value of lease payments and any guaranteed residual value equals or exceeds substantially all of the fair value

Specialized nature of the asset

Met

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