Lease Purchase option under ASC 842
Lease purchase options, also known as lease-to-own agreements, are a popular method of acquiring fixed assets for businesses. In this blog, we’ll explore what lease purchase options are, how they intersect with fixed assets and lease accounting, and provide a full example to help illustrate the concepts.
What are Lease Purchase Options?
Lease purchase options allow businesses to lease an asset with the option to purchase it at the end of the lease term. This allows companies to use an asset for a period of time without the upfront cost of purchasing it outright. Once the lease term has ended, the company has the option to purchase the asset for a predetermined price.
These option can be advantageous for companies that may not have the capital to purchase an asset outright or may not want to commit to a long-term asset purchase. It can also be beneficial for businesses that need to use an asset for a limited period of time, as they can simply return the asset at the end of the lease term if they no longer need it.
Intersection of Lease Purchase Options and Fixed Assets
Fixed assets are assets that are used in a business for more than one year and are have a long-term value. Examples of fixed assets include property, plant, and equipment (PP&E), vehicles, and machinery. Lease purchase options intersect with fixed assets in that they allow companies to acquire fixed assets without the upfront cost of purchasing them outright.
When a company enters into a lease purchase option agreement, they are essentially leasing a fixed asset for a period of time. During this time, the company is responsible for paying rent on the asset, but does not have ownership. Once the lease term has ended and the company has exercised their option to purchase the asset, ownership is transferred to the company.
Intersection of Lease Purchase Options and Lease Accounting
Lease accounting is the process of accounting for leases in a company’s financial statements. In 2019, the Financial Accounting Standards Board (FASB) issued new lease accounting standards (ASC 842) that require companies to recognize lease assets and liabilities on their balance sheet for all leases with terms greater than 12 months.
When a company enters into a lease purchase option agreement, they are essentially entering into a lease agreement with the option to purchase the asset at the end of the lease term. Under ASC 842, companies must recognize a lease liability and lease asset for the entire lease term, regardless of whether they plan to exercise their option to purchase the asset.
This means that during the lease term, the company must recognize a lease liability on their balance sheet for the present value of lease payments, as well as a corresponding lease asset. The lease asset represents the right to use the fixed asset during the lease term.
If the company exercises their option to purchase the asset at the end of the lease term, the lease asset and lease liability are extinguished, and the fixed asset is recorded on the company’s balance sheet as a purchased fixed asset. If the company chooses not to exercise their option to purchase the asset, the lease liability and lease asset are extinguished, and the company returns the fixed asset to the lessor.
Example of a Lease Purchase Option
ACME Company is a manufacturing company that produces automotive parts. They require a new production line to meet the growing demand for their products. To acquire the production line, they enter into a lease agreement with a supplier. The lease agreement has a lease term of five years and an option to purchase the production line at the end of the lease term for $1,000,000.
Under ASC 842, ACME Company must classify the lease as either an operating lease or finance lease. To do this, they must determine if the lease meets any of the following criteria:
- Transfer of ownership: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- Purchase option: The lease includes an option to purchase the underlying asset, and it is reasonably certain that the lessee will exercise that option.
- Lease term: The lease term is for the major part of the economic life of the underlying asset.
- Present value of lease payments: The present value of the lease payments, plus any residual value guaranteed by the lessee, equals or exceeds substantially all the asset’s fair market value.
In this case, the lease agreement includes a purchase option that is reasonably certain to be exercised, and the purchase price is significant relative to the fair value of the production line. Therefore, the lease qualifies as a finance lease.
To account for the lease under ASC 842, ACME Company must recognize a right-of-use asset and a lease liability on their balance sheet. The right-of-use asset represents the lessee’s right to use the production line during the lease term, whilethe lease liability represents the lessee’s obligation to make lease payments over the specified period.
Assuming the lease payments are $200,000 per year, the present value of the lease payments is $900,000, and the fair value of the production line is $1,200,000, ACME Company would recognize the following on their balance sheet:
Right-of-use asset: $1,200,000
Lease liability: $900,000
Each year during the lease term, ACME Company would amortize the right-of-use asset and record interest expense on the lease liability. At the end of the lease term, they would either exercise the purchase option and record the production line as an asset, or return the production line to the supplier.
If ACME Company decides to exercise the purchase option and buy the production line for $1,000,000, they would record the following journal entry:
Production line: $1,000,000
Cash: $1,000,000
If they decide not to exercise the purchase option and return the production line to the supplier, they would derecognize the right-of-use asset and the lease liability, and record the following journal entry:
Lease liability: $900,000
Right-of-use asset: $1,200,000
Gain on lease termination: $300,000
Lease purchase options can be a great way for companies to acquire fixed assets without having to pay for them outright. However, it is important to understand their accounting implications as they can have a significant impact on a company’s financial statements. By following the steps outlined in this example, companies can properly account for lease purchase options and ensure that their financial statements are accurate and reliable.
