Lease purchase options provide companies with the opportunity to convert a lease into a fixed asset. These options allow lessees to exercise their right to purchase the leased asset during or at the end of the lease term. In this blog post, we will explore how lease purchase options work and the accounting implications they entail, specifically under ASC 842 regulations. Understanding these options is essential for businesses seeking to effectively manage their lease agreements and financial statements.
The Mechanics of Lease Purchase Options:
When a company leases an asset, it gains the right to utilize the asset for a specified period. However, there may come a point when the lessee decides to acquire ownership of the asset. While this can be achieved through negotiation with the lessor, many lease agreements incorporate a lease purchase option. This embedded option allows the lessee to purchase the underlying asset under predetermined conditions.
How Does a Lease Purchase Option Work?
The lessee can exercise a lease purchase option by notifying the lessor. Typically, the lease agreement specifies a purchase price and a specific time frame during which the option becomes available. While the details may vary from lease to lease, the fundamental principle remains constant—the decision to exercise the option lies solely with the lessee. This option to purchase introduces specific accounting considerations under ASC 842.
Lease Purchase Options Accounting Implications under ASC 842:
When a lease includes a purchase option, it must be properly recognized and accounted for according to ASC 842 guidelines. The accounting treatment depends on whether the lessee is likely or not likely to exercise the option. The threshold for “likely to exercise” is relatively high, requiring more than just a higher probability. If deemed likely to exercise, the asset is amortized over its useful life instead of the lease term, which is typically a longer period.
Bargain Purchase Options:
A special case of a lease purchase option is a bargain purchase option. This option is structured to give the lessee a strong economic incentive to purchase the asset. Often referred to as a “dollar purchase option,” it allows the lessee to buy the asset for a nominal price at the end of the lease term. However, a bargain purchase option is not limited to a dollar value. If the purchase price is significantly below the asset’s fair value, it is classified as a bargain purchase.
In the case of a bargain purchase option, accounting rules dictate that it must be accounted for as if the lessee will exercise the option. Regardless of the likelihood of exercise, the asset is amortized over its useful life rather than just the lease term. This accounting treatment ensures that failing to exercise a bargain purchase option would be against the lessee’s economic interests.
Purchase Election without a Purchase Option:
In situations where a lease does not have a purchase option, but the lessee elects to purchase the asset at a later stage through an agreement with the lessor, there is a methodology for exercising the purchase price. This includes adjusting the value of the consideration paid and automatically updating the fixed asset register by replacing the intangible right-of-use asset with the value of the asset and accumulated depreciation.
Lease purchase options offer companies the flexibility to convert leases into fixed assets by exercising their right to purchase the leased asset. Understanding the intricacies of lease purchase options and their accounting implications under ASC 842 is crucial for accurate financial reporting. By effectively managing lease agreements and accounting for lease purchase options, businesses can streamline their lease administration and maintain compliance with accounting standards while making informed decisions regarding asset acquisition.
