Hello and welcome everyone to our lesson today. Today I am going to cover a scenario where there is at the lease contract, a purchase option at the end or the middle of the lease, wherever, the lessor is offering the lessee to purchase the leased equipment or the leased asset. This as we know, the purchase price will be included from both perspectives, the lessee and the lessor, as an additional lease payment. So it will be included when we calculate the present value of the lease payments. It will be just accounted as an additional lease that will be taken into consideration when we calculate the lease receivable or the lease payable from the lessee point of view. Let's take an example. Universal Inc, Corporation, leased a high-tech electronic equipment from United Cooperation on January first, 2021. Some of the related information, the lease term is nine years, the annual payment is 25,000. That is the economic life of the asset is 12 years, and the implicit rate for the lessor is 10 percent, which is equal to the lessee's incremental borrowing rate. Now here is the more important additional information. United recently acquired the equipment at a cost of $180,000, which is its favor. United granted Universal the option to purchase the equipment at the end of the lease, which is December 31st, 2029, at the very last end of the lease. Notice that the last payment is going to be December 31st, 2028, but because the lessee is paying the payment at the beginning, that's why the lease will end on December 31st, 2029. The purchase that is allowed to calculate, the lessor is allowing the lessee to purchase at that time the leased equipment for 50,995. Obviously, that number was not randomly selected, it's just the numbers for it to match. The exercise of that option by the Universal seems reasonably certain, and obviously, that will qualify the lease contract to be a finance lease from the lessee point of view and a sales-type from lessor's point of view. Let's take a look how the accounting treatment of the lease contract from the lessee and lessor will be affected by including that purchase option or the purchase price. From the lessee's point of view, here is the right-of-use asset. Now the right-of-use asset and the lease payable is 180,000. How did we calculate that? Here you go. I took the 25,000, which is the annuity due, multiplied by the present value factor. Obviously, any financial calculator would give you that and I'll show you in Excel also how do we calculate those present values. Very neat, very convenient and actually will be helpful when we build the amortization table that will be accounted for during the lease term. That is basically the present value of all the lease payments, the periodic payment, plus the purchase option. That's how the lessee got 180,000, which is equal to the fair value of the asset, then obviously it is a financial lease. For the lessee on December 31st, I will make another payment. Notice that the first payment that we did in the previous slide, a whole 25,000 was accounted for as a reduction in the lease payable because interest expense was not incurred yet. Now, the lease payment will be decomposed into two portions. Now, the interest expense is 15,500. How did we calculate that? Simply the 180,000, which is the lease payable minus the 25,000 that was paid on January first at the beginning of the lease. Then I will incur the interests at 10 percent the balance, which is 155,000 and basically the 10 percent will be 15,500. Now how did I calculate the amortization expense, which is the 15,000? Now the amortization expense will be calculated based on the right-of-use asset divided by 12 years. The 12 years now is the useful life of the asset and now I will not amortize based on the lease term, the nine years, because it will be actually assumed that if the lessee will certainly exercise the purchase option, then the lessee will actually amortize the right-of-use asset over the 12 years, which is going to be $15,000. What about the lessor? Very good. The lessor will actually have a lease receivable. Again, the 180,000, the mirror image of what we did in the lessee, and 180,000 will be calculated. As we notice, it's the present value of the lease payments, which is the periodical lease payment 25,000, plus the purchase price which is expected to be received at the end of the lease. Calculating the present value of those two amounts will give you the 180,000. I have a cash that will be collected that will reduce the lease receivable on January first, 2021. Now, let's take a look at December 31st, which is the second lease collection, that second lease payment. Now it is going to be recognized as a debit to cash and there is an interest revenue for 15,500. As we did with the lessee, the simple thing that the interest revenue is calculated based on the balance of the lease receivable at the beginning of that period, which is the 180,000 minus the 25,000 and that will give me the 15,500. Let's take a look at how that purchase option will look like in an excel sheet. I actually generated that worksheet from the lessee point of view, the lessor point of view. I tried to zoom it as much as I can, but I just wanted to show you the two pictures together. The lessee and the lessor side. Those red amounts I added versus I built a very normal sales without the purchase options so that you can compare between a case where I do not have a purchase option, where the lease payable will be amortized to zero, and the lease receivable will be amortized to zero and obviously there is no additional payment here, and on December 31st, 2000 and December 31st, 2028. Now, when we go to the purchase and here is the example, very straightforward finance and sales type but there is no purchase option. Now, if you go to the purchase option, you will see that I added those in red, which is the fair value and the cost and the purchase option that will be calculated, and that's why the present value of the lease payable will give you the present value of all the lease payments, including the purchase option or the purchase price. I actually also added a single line row for the purchase price, which will be paid on December 31st, 2029, and that is the selling price, which I will calculate it, and that is actually getting to the lease payable to be completely amortized and the leas receivable to be also completely amortized. One last thing that I want to point your attention to in this Excel or the spreadsheet, is that one of the things that you want to notice that the amortization of the asset will actually continue beyond the lease term. Now the lease payable will be on the lessee will be amortized completely by December 31st, 2028 actually and that December 31st, 2029, by paying the purchase price. If you notice those three different additional amortization of the right-of-use asset, because we are amortizing that asset given its useful life, which is 12 years and that's why there are three additional amortization entries that will be added after the lease term from the lessee's point of view. Now, again, the amortization table of the lessee. I always wanted to focus on the amortization table of the payable from the lessee point of view and the receivable from lessor's point of view. This is another case where the amortization table is still the same because the purchase price was included in the calculation of the present value from both perspectives and they're using the same interest rate. That's why it makes it that the amortization of the lease payable from the lessee and the lease receivable from the lessor is going to be exactly mirror image of each other. Hopefully, that example shed some light on the purchase options scenario when it is in a lease contract. Thank you very much.
