Understanding Lease Purchase: Accounting and Implications

Leasing is a common practice in business, allowing companies to acquire assets without a hefty upfront cost. However, situations arise where a lessee wants to transition from leasing to outright ownership, leading to a “lease purchase” scenario. 

In this blog post, we’ll delve into what a lease purchase option entails, its accounting nuances, and the tax implications that come with it.

What is a Lease Purchase Option?

Before diving into the accounting and tax considerations, let’s clarify what a lease purchase option is. A lease purchase option gives a lessee the right, but not the obligation, to buy the leased asset from the lessor. This option can be exercised at a predetermined price, often referred to as the “purchase option price,” which could be a nominal amount or a percentage of the asset’s market value.

Accounting for Lease Purchase:

1. Lease Purchase Out of a Lease: If a lessee decides to purchase an asset they were previously leasing, and the lessor agrees, it’s a straightforward transition. There’s no need for advanced accounting; the asset shifts from being a leased asset to a fixed asset on the books. The accumulated amortization shifts to fixed asset depreciation, and any associated taxes are factored in. Essentially, it’s treated like any other purchase.
2. Lease Purchase Option: When the lessee holds a purchase option, the accounting approach hinges on their intent to exercise it. If the lessee doesn’t anticipate exercising the option, the lease is accounted for as a regular lease. However, if the lessee intends to exercise the option, a different accounting schedule is crafted based on that impending purchase.

Lease Classification Test:

For the lease classification test, the timing of asset ownership transfer becomes vital. If it’s likely that ownership will transfer at the option’s exercise, the underlying asset isn’t amortized over the lease term but over the asset’s useful life.

Lease Purchase Tax Implications:

The tax implications can be substantial when considering a lease purchase option. If you account for the asset as likely to be purchased at the lease term’s midpoint or end, you amortize the asset value over its useful life. For example, if the leased asset is a vehicle with an 8-year useful life, your amortization occurs over 8 years, impacting expense profiles.

Bargain Purchase Option:

A “bargain purchase option” presents another dimension. This means there’s a compelling economic incentive to exercise the option due to a nominal or low purchase price. Even if the lessee initially doesn’t intend to exercise the option, accounting assumes that they will due to the economic incentive.

Changing Intent and Remeasuring:

If intent changes—say, from planning to exercise the option to not exercising it—the lease is remeasured. This might change the lease classification, switching from finance to operating lease treatment.

In conclusion, a lease purchase option introduces complexities to accounting and tax implications. Your approach depends on your intent to exercise the option, the asset’s useful life, and potential bargain purchase incentives. Consulting with accounting professionals can provide clarity and ensure compliance with accounting standards and tax regulations. Understanding the intricacies of lease purchase options empowers businesses to make informed decisions about their assets and financial strategy.