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Capital Lease Buyouts

L. Keith Jordan
Earlier in November, a website visitor asked, "Is the buyout of a purchase option a current expense?" I decided this might be a good time to discuss the difference between the terms "expense" and "expenditure," and how they relate to purchase options.

First let's discuss terminology. An expense is the recognition of resources used to generate revenue. The cost related to an expense may involve an immediate cash outlay; an accrual of an obligation to pay for goods or services (accounts payable); debt service (interest portion); depreciation on assets; etc.

In contrast, an expenditure is an outlay of resources to acquire a benefit or entitlement. Most expenses (other than non-cash expenses such as depreciation) are also expenditures, but many expenditures are not treated as expenses. For instance, payment of principal on a note payable or payment of cash for an asset would not be treated as an expense.

The foregoing should adequately address the issue of terminology. Now let's discuss the issue of purchase options, or buyouts, as applied to the lessee.

I posted an article a few months ago concerning capital leases and buyout options, and their treatment in QuickBooks. As their name implies, purchase options give the buyer the right, but not the obligation, to purchase an underlying asset. The underlying asset could be shares of stock, a vehicle, a copier, or other item of value.

Costs related to leases can be treated in a couple of different ways. The presence of a purchase option can be a factor in determining proper accounting treatment, but it is not the sole determinant.

Under historic treatment, costs related to operating leases (with or without a buyout option) are treated as "off-balance sheet" (included on the income statement). When the buyout option is exercised, the exercise price (or purchase price) is capitalized as part of the acquisition cost of the asset. Relating this treatment to our earlier terminology discussion, the cost of exercising the option is an expenditure, not an expense.

Unlike operating leases, costs related to capital leases are booked directly to the balance sheet. All costs of acquisition become part of the capitalized cost of the asset.

An operating lease with a bargain purchase element is somewhat of a hybrid arrangement. The bargain purchase element could be a $1 buyout, but it could also be more -- as long as it is substantially less than the estimated fair market value of the asset at the time the option is exercised.

The bargain purchase option (BPO) lease was originally constructed in an attempt to allow lessees to expense most of the cost of an item prior to option exercise even though it will eventually be booked as an asset . As a practical matter, good accounting practice requires that such a lease be treated as a capital lease.

The rules on leases are changing for both lessor and lessee. Proposed rules by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) indicate their preference for lessees to capitalize all leases under a single, uniform approach. If that occurs, previous issues regarding proper accounting treatment by lessees for operating leases and BPOs would be rendered moot.