Jack and Gillian Grant, owners of Grant’s Ice Cream Shop Ltd., have recently expanded their business by moving into a second location in a nearby town. To open the second location, the company had to obtain three large ice cream machines. To buy the machines would have cost over $15,000, so Jack and Gillian decided to lease them instead.
The lease term is for five years and the machines are expected to have a useful life of eight to 10 years. According to the lease contract, the present value of the lease payments over the lease term is $12,000 and the Grants will have the option to purchase the leased machines for $1,000 at the end of the five-year lease term. Their fair market value is expected to be approximately $4,000 at the end of the lease.
Jack Grant is thrilled with the arrangement. “Not only do we get the machines that we need without a large initial cash outlay, but we don’t have to record any liability on the statement of financial position; we can just report the annual lease payments as equipment rental expense on the statement of income.”
Required:
Is Jack correct in assuming that the lease payments will be recorded as an expense and that no debt will have to be reported on the statement of financial position as a result of this transaction? Explain your answer fully, by referring to the criteria for lease classification and the appropriate accounting treatment for this type of lease.