Bargain-Purchase Option Test

Definition

The term bargain-purchase option test refers to one of four capitalization criteria used by lessees to account for a leased property.  A bargain-purchase option allows the lessee to purchase the leased property at a price that is significantly below its market value on the exercise date.

Explanation

Companies oftentimes enter into contractual agreements that include the right to use specific property.  Since the terms and conditions of these contracts will vary, the Financial Accounting Standards Board issued FAS No. 13 - Accounting for Leases, which outlines the criteria used to determine if the agreement should be treated as a capital versus operating lease.

If the agreement fails the bargain-purchase option test, then the lessee should treat the agreement as a capital lease.  A bargain-purchase option is defined as an agreement containing a provision that allows the lessee to purchase the property on the exercise date at a price that is significantly below the property's forecasted fair market value.  The option price and expected fair market value of the property must be large enough at the inception of the lease such that the lessee is reasonably assured to exercise this option.

There are a total of four capitalization criteria used by lessees to determine if the property should be treated as a capital lease.  If the agreement fails any of the four tests, then the arrangement should be treated as a capital lease.  The other criteria include: a transfer of ownership test, an economic life test, and a recovery of investment test.

Example

Company A has entered into a ten year lease agreement with Company XYZ for 60,000 square feet of office space.  The agreement allows Company A to purchase the space after 84 months at a price of $3,000,000.  Similar office space in that area would be expected to sell for closer to $7,000,000.

Since the contract contains a bargain-purchase provision, Company A should account for the agreement as a capital lease.

Related Terms

operating lease, capital lease, transfer of ownership test, economic life test, economic life, recovery of investment test, economic life test, economic life, executory costs, minimum lease payment, guaranteed residual valueunguaranteed residual value