Bargain Purchase Option

Definition

A bargain purchase option is a clause within a lease agreement that provides the lessee with the option to purchase the leased asset at the end of the lease term for a significantly lower price than its fair market value. This is often an indication that the lease is, in practice, a transfer of ownership, rather than a straightforward lease. Under accounting standards, a lease that includes a bargain purchase option is typically classified as a capital lease rather than an operating lease.

Examples

Example 1: Equipment Lease

A company leases a piece of manufacturing equipment for 10 years. The equipment’s fair market value at the end of the lease term is expected to be $50,000. The lease agreement includes a bargain purchase option allowing the company to purchase the equipment for $10,000 at the end of the lease. Given the substantial difference between the purchase price and the market value, the bargain purchase option is clearly evident.

Example 2: Vehicle Lease

An automotive company leases a fleet of vehicles to a delivery business for five years. At the end of the lease, the fair market value of the vehicles is projected to be $200,000. The lease contains a bargain purchase option allowing the delivery business to buy the vehicles for $20,000, which is a fraction of their fair market value. This bargain purchase option categorizes the lease as a capital lease in accounting records.

Frequently Asked Questions

What is the primary accounting implication of a bargain purchase option?

A bargain purchase option results in the lease being classified as a capital lease rather than an operating lease in the lessee’s financial statements. This means the lessee must recognize the leased asset and a corresponding liability on their balance sheet.

How does a bargain purchase option affect depreciation?

Because the lessee effectively gains ownership of the asset through a bargain purchase option, they can depreciate the asset over its useful life, commencing from the lease inception date.

What criteria define a bargain purchase option?

A bargain purchase option is typically defined by the option price being significantly lower than the anticipated fair market value of the asset at the time the option is exercisable.

Are there any tax implications of a bargain purchase option?

Yes, a bargain purchase option may lead to different tax treatments. The lessee may get to claim depreciation deductions, which can reduce taxable income.

How do you account for a bargain purchase option under IFRS 16?

Under IFRS 16, leases with bargain purchase options are classified as finance leases, requiring the lessee to recognize both an asset and a liability at the lease commencement date.

Capital Lease: A lease classified as an asset and liability on the lessee’s balance sheet, treating the leased asset as if it were purchased.
Operating Lease: A lease that does not transfer the right of ownership from the lessor to the lessee and is treated as a rental agreement in accounting records.
Fair Market Value: The price at which an asset would trade in a competitive auction setting.
Finance Lease: Under IFRS, any lease that substantially transfers the risks and rewards of ownership to the lessee.

Online References

Suggested Books for Further Studies

“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
“Financial Accounting” by Robert Libby, Patricia Libby, and Frank Hodge
“Accounting for Leases” by Steven M. Bragg
“Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso

Accounting Basics: “Bargain Purchase Option” Fundamentals Quiz

### What type of lease is typically associated with a bargain purchase option? - [x] Capital lease - [ ] Operating lease - [ ] Short-term lease - [ ] None of the above > **Explanation:** A lease with a bargain purchase option is classified as a capital lease because it essentially represents a transfer of ownership. ### Why does a lease with a bargain purchase option get classified as a capital lease? - [ ] Because it has lower payments - [ ] Because it is short-term - [x] Because it effectively transfers ownership to the lessee - [ ] Because it avoids taxes > **Explanation:** The presence of a bargain purchase option indicates that the risks and rewards of ownership are transferred to the lessee, thus classifying it as a capital lease. ### How does a bargain purchase option affect the lease value on financial statements? - [ ] It has no effect - [ ] It increases liabilities but not assets - [ ] It increases assets but not liabilities - [x] It both increases assets and liabilities > **Explanation:** A bargain purchase option necessitates recognizing both the asset and liability on the balance sheet, reflecting the transfer of ownership. ### When can the lessee exercise the bargain purchase option? - [ ] At the lease commencement date - [ ] Anytime during the lease term - [x] At the end of the lease term - [ ] Only on decision of the lessor > **Explanation:** The bargain purchase option is typically exercisable at the end of the lease term. ### What concept does the bargain purchase option challenge in lease accounting? - [ ] Revenue recognition - [ ] Asset impairment - [x] Leasing vs. ownership dichotomy - [ ] Cash flow classification > **Explanation:** The concept challenges the dichotomy between leasing and ownership, affecting how the lease is classified. ### What financial benefit does a bargain purchase option provide the lessee? - [ ] Reduced operational expenses - [ ] Enhanced liquidity - [x] Asset ownership at below-market cost - [ ] None of the above > **Explanation:** The lessee can acquire the asset for a significantly lower price than the market value, providing financial benefit. ### In terms of accounting standards, what does a bargain purchase option signify? - [ ] Higher taxes - [ ] Immediate expense recognition - [x] A finance lease under IFRS and a capital lease under GAAP - [ ] A short-term financial commitment > **Explanation:** It signifies a finance lease under IFRS and a capital lease under GAAP due to the underlying transfer of ownership. ### For financial reporting, what must be recorded by the lessee when a lease includes a bargain purchase option? - [ ] Only the liability - [ ] Only the asset - [x] Both the asset and the liability - [ ] Neither, it remains off-balance sheet > **Explanation:** Both the asset and the related liability must be recorded, reflecting the transfer of ownership inherent in the lease terms. ### In what situation is depreciation recorded by the lessee on a leased asset? - [ ] If it’s a short-term lease - [ ] If there’s no purchase option - [x] If there’s a bargain purchase option - [ ] If the lease payments are waived > **Explanation:** Depreciation is recorded by the lessee if there’s a bargain purchase option since the lessee effectively gains ownership. ### Can a bargain purchase option affect cash flows statement presentation? - [ ] No, it has no effect. - [ ] Yes, as a financing activity. - [x] Yes, as both operating and financing activities. - [ ] Yes, but only marginally. > **Explanation:** It can affect the cash flow statement by impacting both operating and financing activities, reflecting payments and asset acquisition.

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