Purchase Option Price (POP) in lease agreement
The purchase option price is an offer given to the lessee at the start of a lease. It allows the lessee to buy the asset at the end of the lease for a price lower than its expected fair value. For example, if an asset's fair value at the end of the lease is $100,000, the lessee might be offered the option to buy it for $40,000. This encourages the lessee to buy the asset.
If a lease includes this option, it is considered as a finance lease. The cost of the asset should be spread over its economic life, not just the lease term. For example, if the lease term is 8 years and the asset's economic life is 10 years, the cost should be recovered over 10 years. This is because the lessee is likely to keep the asset due to the low purchase option price.
If the lease does not include a purchase option price but targets a guaranteed residual value, amortization should be over the lease term or the remaining economic life, whichever is shorter. This helps determine the amortization period for the Right of Use (ROU) Asset.
By CA L.Muralidharan and CPA L.Mukundan
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