What it means
The clause looks harmless in a lease document but it carries real accounting weight. If the end-of-lease price is far below expected market value, the lessee is economically certain to buy, so the substance of the transaction is that the lessee is acquiring the asset and paying for it in instalments.
Under current lease standards, most leases already appear on the balance sheet as a right-of-use asset and a lease liability, so the option matters slightly differently than it did before. It affects the measurement of the liability, because the option price is included in the payments discounted, and it affects the depreciation period, because an asset the lessee will end up owning is written off over its full useful life rather than the lease term.
The test is about the size of the discount, not the label on the clause. An option to buy at the asset's expected market value is a normal purchase option and changes nothing, whereas an option to buy at a small fraction of expected value is a bargain option and triggers the different treatment.
For managers, the practical consequence is that these clauses affect reported debt and covenant calculations. Sales teams sometimes present a bargain option as a benefit with no cost, but the lease liability recognised will be larger and the asset will sit on the balance sheet for longer, which can matter for gearing ratios.
In practice
Real-world examples.
Example
A haulage company leases 20 trucks over four years with an option to buy each for $5,000 when the market value is expected to be around $28,000. The finance team includes the total $100,000 option price in the lease liability and depreciates the trucks over eight years.
Example
A dental practice leases imaging equipment with an option to buy for $1 at the end of the term, a structure often used where the lease is effectively a loan. The arrangement is accounted for as a purchase from the outset, and the practice's reported borrowings rise accordingly.
Example
A software company leases office fit-out equipment with an option to buy at estimated market value at the end of five years. Because the option price is not a bargain, it is excluded from the liability calculation and the assets are written off over the lease term.
Formula
Calculation
Lease liability = present value of lease payments + present value of the bargain purchase option price, discounted at the rate implicit in the lease.
A printing business leases a press for five years, paying $40,000 at the end of each year, with an option to buy the press for $20,000 at the end of the lease. The press is expected to be worth about $95,000 at that point, so the option is clearly a bargain. The rate implicit in the lease is 7%.
Present value factor for five annual payments at 7%: 4.100197.
Present value of lease payments: $40,000 x 4.100197 = $164,008.
Present value of the $20,000 option: $20,000 / (1.07 to the power of 5) = $20,000 / 1.402552 = $14,260.
Total lease liability recognised: $164,008 + $14,260 = $178,268.
The right-of-use asset is recorded at $178,268 and, because ownership is expected to transfer, it is depreciated over the press's full useful life of, say, ten years rather than the five-year lease term, giving annual depreciation of $17,827.Case study
Seen in the real world.
Larkspur Bakeries is a fictional bakery chain presented here as an illustrative example. It agreed a five-year lease on a new oven line with annual payments of $40,000 and an option to buy for $20,000 at a point when the equipment was expected to be worth around $95,000, and the sales representative described the option as a free upside.
The finance manager pointed out that including the option added $14,260 to the lease liability and, more importantly, extended depreciation from five years to ten because ownership would transfer. That raised recognised debt to $178,268 and pushed the company uncomfortably close to a banking covenant that capped total borrowings at $2,000,000.
The illustrative resolution was to renegotiate the deal into a straight rental with no bargain option and a slightly higher annual payment, keeping the covenant headroom the business needed. The point is that a clause described as costing nothing changed both the balance sheet and the company's borrowing capacity.
Watch out
Common mistakes.
- Assuming any purchase option makes a lease a finance arrangement. Only an option priced well below expected fair value counts, since an option at market value gives the lessee no compelling reason to buy.
- Leaving the option price out of the lease liability. It is a payment the lessee is expected to make and must be discounted and included.
- Depreciating the asset over the lease term when ownership is expected to transfer. The correct period is the asset's full useful life, which changes the annual charge significantly.
Questions
People also ask.
How big does the discount have to be?
There is no fixed percentage, but the test is whether exercise is reasonably certain, and a price at a small fraction of expected value clearly meets it.
Does this affect debt covenants?
Yes, since the option increases the recognised lease liability, which most modern covenant definitions count as borrowing.
Is a $1 buyout option a bargain purchase option?
Almost always, and such leases are usually treated as purchases financed by the lessor from the start of the term.
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