Bargain Purchase Option

What Is a Bargain Purchase Option?

A bargain purchase option is a clause in a lease agreement that permits the lessee to purchase the leased asset toward the finish of the lease period at a price substantially below its fair market value.

Understanding a Bargain Purchase Option

The Financial Accounting Standards Board (FASB) characterizes a bargain purchase option as a provision that permits a lessee to purchase the leased property "at a cost which is adequately lower" than the expected fair value at the date that the option can be worked out.

The bargain purchase option is one of four criteria under the FASB Statement No. 13, any of which, whenever fulfilled, would require the lease to be classified as a capital or financing lease, rather than a operating lease, that must be uncovered on the lessee's balance sheet. Under a capital lease, the leased asset is recorded as owned by the company though an operating lease permits the utilization of an asset however doesn't convey ownership.

The objective of this classification is to forestall off-balance-sheet financing by the lessee. Under an operating lease, a company wouldn't need to record assets or liabilities, like rent payments, associated with the lease on its balance sheet. This has given the opportunity to firms to keep huge amounts of assets and liabilities off of a company's balance sheet, working on their debt-to-equity ratio.

The other three criteria that the FASB expects for a lease to be recorded as a capital lease incorporate a transfer of title/ownership when the lease is finished, the lease term being 75% or a greater amount of the asset's economic life, and the current value of the base lease payments toward the beginning of the lease being 90% or a greater amount of the asset's fair market value.

For instance, expect that the fair market value of an asset toward the finish of the lease period is estimated at $100,000, yet the lease agreement has an option that empowers the lessee to purchase it for $60,000; a figure substantially below the fair market value. This would be viewed as a bargain purchase option and would require the lessee to regard the lease as a capital lease.

Accounting for a Lease with a Bargain Purchase Option

There are massive differences in the accounting treatment of capital leases versus operating leases. In the event that a lease has a bargain purchase option, the lessee must record the asset as a capital lease in an amount equivalent to the present value of all base lease payments over the lease term.

During the lease term, every base lease payment ought to be allocated between a reduction of the lease obligation and interest expense. Capital leases and their accumulated amortization must be uncovered on the balance sheet or in the notes to the consolidated financial statements.

Features

• A bargain purchase option in a lease permits the lessee to purchase the leased asset when the lease period is over at a price below the fair market value.
• Under the Financial Account Standard Board's rules, a bargain purchase option would require the lessee to regard the lease as a capital lease instead of an operating lease.
• The capital lease is recorded in an amount equivalent to the current value of all the base lease payments over the term of the lease.