On January 1, 2016, Bountee Ltd. leased a machine from Vector Equipment Ltd. The machine had cost Vector $480,000 to manufacture, and would normally have sold for about $600,000. The lease was for 10 years and requires equal semi-annual payments of $40,000 to be made each June 30 and December 31, which reflects an annual interest rate of 10%. While the machine is expected to have a total useful life of 12 years, Bountee’s management plans to return it to Vector at the end of the 10-year lease. Bountee’s management has also determined that the present value of the minimum lease payments was $498,500 at the time the lease was entered into.

Required:

a. Prepare and complete a table based on the one below. Conclude on whether the lease should be classified as an operating or finance lease.

CriterionHow does it apply?

Ownership transfers at the end of the lease

Lessee has the option to purchase the asset at the end

of the lease for less than fair value

Lease term represents most of the useful life of

the leased asset. Present value of the minimum lease

payments represents sub-statically all of the fair value

of the leased asset at the time the lease is entered into

Leased asset is highly specialized and could not be

used by others without major modifications

b. Would your assessment in part “a” change if the lease term was two years longer? What if it was two years shorter?

c. If the annual interest rate was changed to 8%, then the present value of the minimum lease payments would have been $458,800. Would this change your assessment in part “a”? Explain.