Garvey Company (the lessee) entered into an equipment lease with Richie Company (the lessor) on January 1 of Year 1. Use the following information to decide whether this lease qualifies as an operating or capital lease for Garvey, and give an explanation using the four classification criteria.
1. The equipment reverts back to the lessor at the end of the lease, and there is no bargain purchase option.
2. The lease term is five years and requires Garvey to make annual payments of $65,949.37 at the end of each year.
3. The discount rate is 10%, which is implicit in the lease. Garvey knows this, and this rate is lower than its incremental borrowing rate.
4. The fair value of the equipment at the lease inception is $250,000. The present value of an ordinary annuity of five payments of $65,949.37 each at 10% is $250,000.
5. The equipment has an estimated economic life of seven years and has zero residual value at the end of this time. Straight-line depreciation is used for similar assets.