Financial Lease Example / Lease With a Bargain Purchase Option
Below is a financial lease example with a bargain purchase option.
A bargain purchase option is a clause in a lease agreement that allows the lessee to purchase the leased asset at the end of the lease period at a price substantially below its fair market value.
Transaction Details
On January 1, 2022, Dian Company leased a machine from Jonna Company for 10 years with the details as follows:
Lease payments every December 31 CU 2,000,000
Useful life of the machine 12 years
Incremental borrowing rate 14%
Implicit interest rate 12%
Present value of an ordinary annuity of 1 for 10 periods
12% 5.6502
14% 5.2161
Present value of 1 for 10 periods
12% 0.3220
14% 0.2697
The mathematical table for the present value of 1 and an ordinary annuity can be obtained here – https://accountingupgrade.com/mathematical-tables/.
Dian Company has the option to purchase the machine at the end of the lease by paying CU 1,000,000 and Dian is reasonably certain that they will exercise the purchase option.
The estimated residual value of the machine at the end of the lease is CU 1,100,000.
Cost of Right of Use Asset
Since there is a certain purchase option, the right-of-use asset is computed as follows:
Present value of lease payments (2,000,000 x 5.6502) 11,300,400
Present value of purchase option (1,000,000 x 0.3220) 322,000
Right of use asset/lease liability 11,622,400
The present value factor for 12% was used in computing the present value of the lease payments since it is the implicit interest rate. However, if the implicit interest rate cannot be readily determined, the lessee can use the incremental borrowing rate.
Table of Amortization
| Date | Payment | Interest | Principal | Present Value |
| Jan. 1, 2022 | 11,622,400 | |||
| Dec. 31, 2022 | 2,000,000 | 1,394,688 | 605,312 | 11,017,088 |
| Dec. 31, 2023 | 2,000,000 | 1,322,051 | 677,949 | 10,339,139 |
| Dec. 31, 2024 | 2,000,000 | 1,240,697 | 759,303 | 9,579,835 |
| Dec. 31, 2025 | 2,000,000 | 1,149,580 | 850,420 | 8,729,415 |
| Dec. 31, 2026 | 2,000,000 | 1,047,530 | 952,470 | 7,776,945 |
| Dec. 31, 2027 | 2,000,000 | 933,233 | 1,066,767 | 6,710,179 |
| Dec. 31, 2028 | 2,000,000 | 805,221 | 1,194,779 | 5,515,400 |
| Dec. 31, 2029 | 2,000,000 | 661,848 | 1,338,152 | 4,177,248 |
| Dec. 31, 2030 | 2,000,000 | 501,270 | 1,498,730 | 2,678,518 |
| Dec. 31, 2031 | 2,000,000 | 321,482 | 1,678,518 | 1,000,000 |
Present value – we have recorded above the recognition of the CU 11,622,400 right-of-use assets which is the present value of the lease payments plus the amount of the certain bargain purchase option as shown in the table below. The present value is the balance of the lease liability after deducting the annual principal payments.
Payment – is the annual lease or fixed payment which is CU 2,000,000.
Interest – is equal to the foregoing present value multiplied by the implicit interest rate of 12%. Thus, for 2022, the interest is CU 11,622,400 x 12% = CU 1,394,688, and for 2023, the interest is CU 11,017,088 x 12% = CU 1,322,051, and so on.
Principal – is the portion of annual rental payments less interest. Thus for 2022, the principal payment nets to CU 605,312 (CU 11,622,400 – CU 1,394,688).
Journal Entries for 2022
1. To record the right-of-use asset and the lease liability:
Dr. Right of use asset 11,622,400
Cr. Lease liability 11,622,400
2. To record the first lease payment on December 31, 2022.
Dr. Interest expense 1,394,688
Dr. Lease liability 605,312
Cr. Cash 2,000,000
Interest expense and lease liability are obtained from the table of amortization which is as follows:
Payment on December 31, 2022 2,000,000
Interest amortization for 2022
Lease liability, January 1, 2022 11,622,400
Multiply by the implicit interest rate 12%
Interest for 2022 1,394,688
Principal amortization 605,312
3. To record the depreciation for 2022.
Dr. Depreciation 876,867
Cr. Accumulated depreciation 876,867
The asset is depreciated over the useful life of 12 years since there is a purchase option that is reasonably certain to be exercised.
The depreciable amount is equal to the cost of the right-of-use asset amounting to CU 10,522,400 (CU 11,622,400 cost – CU 1,100,000 residual value).
Exercise of Purchase Option
On December 31, 3031, as shown in the amortization table above, the remaining present value will be CU 1,000,000 which is equal to the purchase option.
When the purchase option is exercised on January 1, 3032, the lease expiration date, the journal entry will be:
Dr. Lease liability 1,000,000
Cr. Cash 1,000,000
Nonexercise of Purchase Option
However, if the purchase option is not exercised, a loss is recognized equal to the difference between the carrying amount of the right-of-use asset and the lease liability on January 1, 3032.
Dr. Lease liability 1,000,000
Dr. Accumulated depreciation 10,522,400
Dr. Loss on finance lease 100,000
Cr. Right-of use-asset 11,622,400
Right of use asset 11,622,400
Accumulated depreciation 8,768,670
(876,867 x 10 years)
Carrying amount, January 1, 3032 2,853,730
Lease liability, January 1, 3032 1,000,000
Loss on finance lease 1,853.730
Next Lesson – Lease With Guaranteed Residual Value