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Leases with bargain purchase options.

Leases With Bargain Purchase Options

Last month we discussed the difference between operating leases and capital leases. This month's column continues with an explanation of a capital lease that includes a bargain purchase option.

One of the four criteria which may define a capital lease is the presence of a bargain purchase option. This option allows the lessee to purchase the leased property at a bargain price, usually at the end of the lease term. Since a capital lease is similar to the purchase of equipment on credit, the lessee records an asset and a related liability. The amount to be recorded is the present value of the minimum lease payments. The value of the bargain purchase option is included in the total. Let's repeat our example, which is taken from Intermediate Accounting by Smith and Skousen, and add these changes.

Salesy Corporation leases equipment from General Leasing Company. The terms are as follows: Lease period: 5 years beginning January

1, 1992. Noncancellable Rental Amount: $60,000 per year

payable annually in advance Expected economic life of the equipment:

10 years Bargain purchase option of $75,000

at end of lease. Assumed residual value at end of

lease is $90,000. Implicit Rate of Interest is 10%

Using the appropriate tables, we can determine that the present value of the lease payments are $250,194. The present value of the BPO in 1996 is $46,568. Therefore, the total present value of the lease is $296,762. The entries made by the lessee are shown in Table 1: [Tabular Data Omitted]

Table 2 on page 20 shows the reduction of the liability and the interest expense over the five years of the lease. [Tabular Data Omitted]

At the end of the lease, when the bargain purchase option is exercised, the entries made are shown in Table 3, A. If the option is not exercised, the lessee recognizes a loss which is equal to the net remaining balance in the asset account. This is illustrated by the entry shown in Table 3, B. [Tabular Data Omitted]

We can now assume that the capital lease is a sales type lease for the lessor. In this type of lease, the lessor recognizes a gain at the time of the initial transaction. Let's make it easy and also assume that the cost of the asset to the lessor is the same as the fair market value of the asset ($296,762). The entries made by the lessor are shown in Table 4, A. [Tabular Data Omitted]

At the end of the lease, when the bargain purchase option is exercised, the lessor makes the entries shown in Table 4, B.

If at the end of the lease the lessee decides not to exercise the bargain purchase option, the lessor may also recognize a loss. Let's assume in this case that the residual value is now only $60,000 instead of the $90,000 originally assumed. The lessor makes the entry shown in Table 4, C.

As you can see, lease accounting is quite complex. There are more areas to be covered, but it's time for a break. No Own, Inc. acquires equipment under a noncancellable lease at an annual rental of $30,000, payable in advance for five years. After five years, there is a bargain purchase option of $50,000. The appropriate interest rate is 12%. Present value of $1 due in five years at 12% is .5674. Present value of an annuity of $1 per period for five years at 12% is 3.6048; for four years, 3.0373. What is the total present value of the lease and the first year's interest expense? A. $136,514 and $12,782 B. $136,514 and $14,339 C. $149,489 and $17,939 D. $149,489 and $14,339
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Title Annotation:Accounting Scene
Author:Schwartz, Marlyn A.
Publication:The National Public Accountant
Article Type:column
Date:Sep 1, 1991
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