Bargain Purchase Option

What Is a Bargain Purchase Option?

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

Understanding a Bargain Purchase Option

The Financial Accounting Standards Board (FASB) defines a bargain purchase option as a provision that allows a lessee to purchase the leased property "for a price which is sufficiently lower" than the expected fair value at the date that the option can be exercised.

The bargain purchase option is one of four criteria under the FASB Statement No. 13, any one of which, if satisfied, would require the lease to be classified as a capital or financing lease, as opposed to an operating lease, that must be disclosed on the lessee's balance sheet. Under a capital lease, the leased asset is recorded as owned by the company whereas an operating lease allows the use of an asset but does not convey ownership.

The objective of this classification is to prevent off-balance-sheet financing by the lessee. Under an operating lease, a company would not have to record assets or liabilities, such as rent payments, associated with the lease on its balance sheet. This has provided the opportunity for firms to keep significant amounts of assets and liabilities off of a company's balance sheet, improving their debt-to-equity ratio.

The other three criteria that the FASB requires for a lease to be recorded as a capital lease include a transfer of title/ownership when the lease is over, the lease term being 75% or more of the asset's economic life, and the present value of the minimum lease payments at the beginning of the lease being 90% or more of the asset's fair market value.

As an example, assume that the fair market value of an asset at the end of the lease period is estimated at $100,000, but the lease agreement has an option that enables the lessee to purchase it for $60,000; a figure substantially below the fair market value. This would be considered a bargain purchase option and would require the lessee to treat the lease as a capital lease.

Accounting for a Lease with a Bargain Purchase Option

There are significant differences in the accounting treatment of capital leases versus operating leases. If a lease has a bargain purchase option, the lessee must record the asset as a capital lease in an amount equal to the present value of all minimum lease payments over the lease term.

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