Intermediate Financial Accounting II: Chapter 15 - Bargain Purchase Options in Lease Accounting

Definition and Fundamental Concepts of Bargain Purchase Options (BPO)

• Purchase Option Defined: A purchase option is a specific provision within a lease contract that grants the lessee the right to buy the leased asset at a specified point during or at the conclusion of the lease term.
• The "Bargain" Aspect: It is termed a "bargain" purchase option because the exercise price is typically set significantly lower than the expected fair value of the asset at the exercise date. The speaker notes this amount might be relatively small, such as "an additional few thousand dollars."
• Operational Assumptions:
  • Both the lessee and the lessor treat the exercise price of a BPO as an additional cash payment at the end of the lease.
  • For accounting purposes, it is assumed that the lease terminates on the date the BPO is expected to be exercised.

Lease Classification and Criteria

• The Five-Question Framework: The existence of a BPO is one of the five primary criteria used to determine lease classification.
• Reasonable Certainty: If it is "reasonably certain" that the lessee will exercise the purchase option, the lease is automatically classified as follows:
  • Lessee: Finance Lease.
  • Lessor: Sales-type Lease.
• Exclusion of Operating Classification: Because of the BPO and the reasonable certainty of exercise, the lease cannot be classified as an operating lease for either party.

Quantitative Example: Sans Serif Publishers and First Lease Corp

• Parties Involved:
  • Lessee: Sans Serif Publishers.
  • Lessor: First Lease Corp.
• Asset Details:
  • Cost to Lessor: $479,000$.
  • Fair Value at lease commencement: $479,000$.
  • Estimated residual value (end of lease): $75,000$.
  • Useful life of equipment: $7$ years.
• Lease Terms:
  • Commencement Date: $01/01/2021$.
  • Lease Term: $6$ years.
  • Implicit Interest Rate: $10\%$.
  • Payment Schedule: Six annual payments of $92,931$. The first payment is made on $01/01/2021$ (annuity due), with subsequent payments every December 31.
  • Bargain Purchase Option (BPO) Price: $60,000$ (exercisable at the end of the lease).

Present Value (PV) Calculations for Lease Recognition

To determine the initial value of the lease, two separate present value components must be calculated and summed by the lessee:

• Step 1: Present Value of Periodic Payments:
  • Payment Amount: $92,931$
  • Calculation Type: Present Value of an Annuity Due.
  • Parameters: $n = 6$, $i = 10\%$.
  • Formula applied: $\text{Payment} \times \text{Annuity Due Factor}$.
  • Result: $445,211$.
• Step 2: Present Value of the BPO Exercise Price:
  • Exercise Price: $60,000$.
  • Calculation Type: Present Value of a Single Sum (since it occurs only once at the end of the term).
  • Parameters: $n = 6$, $i = 10\%$.
  • Result: approximately $33,789$ (derived from the difference between the total asset value and the PV of payments).
• Total Initial Value: The sum of these two components equals the total Right-of-Use (ROU) asset and the initial Lease Payable, which is $479,000$.

Initial Journal Entries

Lessee Entries (01/01/2021)

• To record the lease recognition:
  • Debit: Right-of-Use (ROU) Asset $479,000$
  • Credit: Lease Payable $479,000$
• To record the first payment (Annuity Due):
  • Debit: Lease Payable $92,931$
  • Credit: Cash $92,931$

Lessor Entries (01/01/2021)

• To record the Sales-type Lease:
  • Debit: Lease Receivable $479,000$
  • Credit: Equipment $479,000$
• To record receipt of the first payment:
  • Debit: Cash $92,931$
  • Credit: Lease Receivable $92,931$

Year-End Journal Entries for BPO Exercise (12/31/2026)

At the end of the lease term, the lessee exercises the BPO. The remaining balance in the Lease Payable (and Lease Receivable) accounts prior to the final BPO payment is $54,542$.

Lessee Entries (12/31/2026)

• Interest Expense Calculation: $54,542 \times 10\% = 5,458$.
• BPO Payment:
  • Debit: Interest Expense $5,458$
  • Debit: Lease Payable $54,542$
  • Credit: Cash $60,000$ (the BPO price)
• Outcome: The Lease Payable balance is reduced to zero.

Lessor Entries (12/31/2026)

• Interest Revenue Calculation: $54,542 \times 10\% = 5,458$.
• Receipt of BPO Payment:
  • Debit: Cash $60,000$
  • Credit: Interest Revenue $5,458$
  • Credit: Lease Receivable $54,542$
• Outcome: The Lease Receivable balance is reduced to zero.

Amortization of the Right-of-Use (ROU) Asset

• Amortization Base: The lessee amortizes the ROU asset based on the useful life of the asset rather than the lease term.
• Rationalization: Because the lease contains a BPO that is reasonably certain to be exercised, ownership effectively transfers to the lessee. Therefore, the asset is consumed over its entire productive life.
• Calculation Parameters:
  • Useful life: $7$ years.
  • Method: Finance lease amortization typically follows the pattern of the asset's economic benefits (straight-line if not specified).