Question

(Lease Capitalization, Bargain-Purchase Option) Baden Corporation entered into a lease agreement for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease in all terms except there is a bargain-purchase option. After the 5-year lease term, the corporation can purchase each copier for \(1,000, when the anticipated fair value is \)2,500.

Jerry Suffolk, the financial vice president, thinks the financial statements must recognize the lease agreement as a capital lease because of the bargain-purchase option. The controller, Diane Buchanan, disagrees: “Although I don’t know much about the copiers themselves, there is a way to avoid recording the lease liability.” She argues that the corporation might claim that copier technology advances rapidly and that by the end of the lease term the machines will most likely not be worth the $1,000 bargain price.

Instructions

Answer the following questions.

(c) What should Suffolk do?

Short answer

Answer

Suffolk must assess the circumstances to avoid being misled by Buchanan.

Step-by-step solution

Step-by-Step Solution

Step 1: Meaning of Bargain-Purchase option (BPO)

A BPO offers the lessee the option to purchase the leased asset at a price that is much lower than the estimated fair value of the asset and appears relatively certain to exercise the option.

Explaining the situation in Suffolk

Suffolk must evaluate if the circumstance provides a reasonable difference of opinion where professional judgment might lead to either a correct or incorrect conclusion or whether Buchanan is attempting to mislead. Suffolk must choose between debating with Buchanan and simply accepting his stance. Suffolk should weigh the pros and drawbacks of both options. Before making a choice, Suffolk may undertake more investigation into copier technology.