Question

Question: (Lessee Entries with Bargain-Purchase Option) The following facts pertain to a noncancelable lease agreement between Mooney Leasing Company and Rode Company, a lessee.

Inception date	May 1, 2017
Annual lease payment due at the beginning of each year, beginning with May 1, 2017	\(21,227.65
Bargain-purchase option price at end of lease term	\) 4,000.00
Lease term	5 years
Economic life of leased equipment	10 years
Lessor’s cost	\(65,000.00
Fair value of asset at May 1, 2017	\)91,000.00
Lessor’s implicit rate	10%
Lessee’s incremental borrowing rate	10%

The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs.

Instructions

(Round all numbers to the nearest cent.)

(b) Discuss the nature of this lease to Mooney Leasing Company.

Short answer

Answer

The lease has a bargain purchase option.

Step-by-step solution

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.

 Step 2: Discussing the nature of the lease

The lease agreement includes a bargain-buy option. Lease payments are generally estimated in terms of collectables, and there is no significant uncertainty about the lessor’s future expenses.

Consequently, from the lessor's point of view, the lease qualifies as a capital-type lease. The lease is classified as a sale-type lease because the initial amount of the lease receivable (net investment) (which equals the present value of the minimum lease payment, in this case, $91,000) exceeds the lessor’s cost ($65,000).