CFA Practice Question

CFA Practice Question

A firm's lease agreement reveals the following:

Lease term = 10 years
Economic life = 15 years
Annual payments = 100,000
Fair value of equipment = 1.3 million
Lessor's implicit rate = 9%
Lessee's incremental borrowing rate = 10%
The agreement contains no bargain purchase option.

The firm's interest expense in Year 1 is close to ______.
A. 0
B. 100,000
C. 61,500
Explanation: The lease term is less than 75% of the economic life. The recorded liability is the present value of 100,000 per year for 10 years, using a discount rate of min(9%, 10%) = 9% - as required by GAAP. Thus, recorded liability = 641,766. This is less than 90% of the fair value of the leased property.

Since none of the 4 conditions of GAAP for capital lease classification is satisfied, the lease must be recorded as an operating lease. In an operating lease, interest expense equals 0.

User Contributed Comments 5

User Comment
gazman1984 I thought you assume with a lease that paid at the beginning of the year. I.e PV not as above. Obv doesnt matter in this specific q.but still..
acemaj If the annual pmt is not classified as an int exp, then what is it classified as?
seon rental payment
MrFortei AN nailed it on this one, Thanks Seon
sshetty2 the operating-lease payment is recorded as an operating expense.
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