We are considering entering into a lease that has a bargain-purchase option. How should we handle
Accounting for lease purchases
Answers
If the lease has a bargain-purchase option then the lease will be classified as a capital lease.
The bargain purchase option is one of the four criteria specified in ASC 840-10-25-1 b). In addition, the Capital lease is defined in the FASB glossary as “From the perspective of a lessee, a lease that meets any of the four lease classification criteria in paragraph 840-10-25-1.”
I have included in my response relevant extracts of the U.S. GAAP accounting literature, that I suggest you include in any
Please feel free to contact me directly if you have any follow-up questions or need any additional inputs on drafting your white-paper to document the accounting for this issue.
RELEVANT U.S. GAAP ACCOUNTING LITERATURE:
Accounting Standards Codification (ASC) 840-10-25-1, Leases - Overall – Recognition, in part states that, “A lessee and a lessor shall consider whether a lease meets any of the following four criteria as part of classifying the lease at its inception under the guidance in the Lessees Subsection of this Section (for the lessee) and the Lessors Subsection of this Section (for the lessor): ……….a) Transfer of ownership. …….b) Bargain purchase option. The lease contains a bargain purchase option. …..c) Lease term. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. ….d) Minimum lease payments. ….”
ASC 840-10-25-29, states that “If at its inception a lease meets any of the four lease classification criteria in paragraph 840-10-25-1, the lease shall be classified by the lessee as a capital lease.”
Capital lease is defined in the glossary as “From the perspective of a lessee, a lease that meets any of the four lease classification criteria in paragraph 840-10-25-1.”
This is a capital lease, accounted for as an acquired asset [amortized] and associated debt, also requiring recognition of interest expense. The sum of interest and depreciation may exceed payments in the early years.
Hi Barrett, you are right in stating the accounting for the capital lease accounting. I will however expand the accounting for the benefit of the other readers that are not familiar with this accounting.
Under capital lease accounting, on day one, the entity will record the asset along with the associated debt.
Similar to any asset acquired by an entity, the entity will be required to record amortization over the life of the asset.
Similar to any debt acquired by an entity, the entity will recognize the interest expense. In addition, the debt would be required to be split in Short-term / long-term debt for disclosure purposes.
To summarize,
Capitalized Asset DEBIT
Long-term obligation CREDIT
Short-term obligation CREDIT
I will like to make an additional point here as it relates to the "cash flows". The actual cash outflow, might be more/less when compared to the combination of interest and amortization expenses. Hence, this is the reason, analysts prefer to make use cash flows in valuing any entity.
In addition, as a lot of entities prefer to keep the assets off-balance sheet, they will do their best to structure the leases as operating leases rather than capital leases. However, there is a new accounting standard in works (both for FASB/IASB) for leases that will require even the assets under operating leases to be recorded on the balance sheet.
Please feel free to contact me with any additional questions on this topic.
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The above comments are spot on. Since it is a capital lease, an amortization table would be set up at acquisition. The bargain purchase option payment should be included in the amortization table. The next 12 months of principal payments would be classified as current. If you are a public or reporting company, the current portion should be trued up on at least a quarterly basis. I would recommend separate asset accounts for capitalized assets under lease, or a separate asset category in your fixed asset sub-ledger.
There are various reporting requirements for capital leases at year-end, so you should refer to the ASC for those.
If you exercise the bargain option at lease end, the asset should be reclassified as a regular asset.
In the unlikely event that you do not exercise the bargain purchase option, the asset, accumulated amortization and remaining capital lease balance (if any) should be removed from the books.
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