How Should the Leases Be Classified and Accounted for?
On January 1,Toronto Company, a lessee, entered into three no cancelable leases for new equipment, lease J, lease K, and lease L. None of the three leases transfers ownership of the equipment to Toronto 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 is 75% of the fair value of the equipment to the lessor at the inception of the lease. This excludes that portion of the payments representing executory costs, such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon. The following information is peculiar to each lease:
(a) Lease J does not contain a bargain purchase option; the lease term is equal to 80% of the estimated economic life of the equipment.
(b) Lease K contains a bargain purchase option; the lease term is equal to 50% of the estimated economic life of the equipment.
(c) Lease L does not contain a bargain purchase option; the lease term is equal to 50% of the estimated economic life of the equipment.
1. How should Toronto Company classify each of the three leases and why? Discuss the rationale for your answer.
2. What amount, if any, should Toronto record as a liability at the inception of the lease for each of the three leases?
3. Assuming that the minimum lease payments are made on a straight line basis, how should Toronto record each minimum lease payment for each of the three leases?