Introduction
A purchase option gives a lessee the right, but not the obligation, to buy the underlying asset during or at the end of the lease term, typically at a stated price, a formula-based price, or fair value at the exercise date. On its own, a purchase option is a small contractual clause—but whether the lessee is reasonably certain to exercise it has an outsized effect on lease accounting under both IFRS 16 and ASC 842.
Under IFRS 16, a reasonably certain purchase option changes the lease term, the measurement of the lease liability, and how the right-of-use asset is depreciated. Under ASC 842, it can go further and flip the entire classification of the lease from operating to finance, changing how lease expense is presented in profit or loss.
This article forms part of our full IFRS 16 guide and our IFRS 16 vs ASC 842 comparison.
What Is a Purchase Option?
A purchase option is a contractual right held by the lessee to acquire the underlying asset. Common structures include:
- Fixed-price options — a stated dollar (or rand) amount payable to obtain ownership.
- Formula-based options — a price determined by a formula, such as a percentage of the original cost or the outstanding lease liability.
- Fair-value options — the lessee may purchase the asset at its fair value on the exercise date.
- Bargain purchase options — a price set low enough, relative to the asset's expected fair value at exercise, that a rational lessee would almost certainly exercise it.
The mere existence of a purchase option does not, by itself, change lease measurement. What matters is whether the lessee is reasonably certain to exercise it—the same high threshold used to assess extension and termination options.
Did you know?
Under IFRS 16, any lease that contains a purchase option is automatically disqualified from the short-term lease exemption, regardless of how likely the lessee is to exercise it. ASC 842 is more lenient here: a lease can still qualify for short-term treatment if the lessee is not reasonably certain to exercise the option. See our short-term and low-value lease guide for the exemption itself.
Assessing Whether Exercise Is Reasonably Certain
"Reasonably certain" is a high threshold under both standards—stronger than "more likely than not"—and is assessed using all relevant facts and circumstances at the lease commencement date. Relevant indicators include:
- Pricing — the exercise price is significantly below the asset's expected fair value at the exercise date (a bargain purchase option).
- Asset specificity — the lessee has made significant leasehold improvements, or the asset has been customised in a way that would lose most of its value to another user.
- Economic dependence — the asset is central to the lessee's operations, and replacing it would be costly or disruptive.
- Contractual and market factors — other terms of the arrangement that make exercise economically compelling.
This assessment is made once, at commencement, and is not revisited unless a significant event within the lessee's control occurs that changes the assessment—consistent with how lease term reassessment works more broadly.
Purchase Options Under IFRS 16
IFRS 16 uses a single on-balance-sheet lessee model, so there is no lessee classification test to trip—but a reasonably certain purchase option still changes three things:
- Lease liability measurement — the exercise price of the purchase option is included, at its present value, within the lease payments used to measure the lease liability.
- Right-of-use asset depreciation — because the lessee expects to obtain ownership, the right-of-use asset is depreciated over the underlying asset's useful life, rather than the shorter of the lease term or useful life that applies to leases without a reasonably certain transfer of ownership.
- Lease term — the lease is, in substance, treated as running through to the point the lessee obtains ownership, since the lessee's use of the asset is not expected to end when the stated lease term does.
For lessors, a purchase option that the lessee is reasonably certain to exercise is one of the indicators that a lease transfers substantially all the risks and rewards of ownership—pointing towards finance lease classification rather than an operating lease.
Purchase Options Under ASC 842
ASC 842 retains the dual lessee model inherited from ASC 840, and a purchase option plays a more decisive role here. One of the five classification criteria for a finance lease is met when:
The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
If this criterion is met, the lease is classified as a finance lease for the lessee (and a sales-type lease for the lessor), regardless of whether any of the other four classification criteria are met.
ASC 842 replaced ASC 840's bright-line "bargain purchase option" test with this broader "reasonably certain to exercise" principle. In practice, a bargain purchase option is still the clearest evidence that exercise is reasonably certain, but the assessment is no longer limited to price alone—asset specificity and economic dependence matter too.
Where the finance lease criterion is met:
- Initial measurement of the lease liability and right-of-use asset mirrors the IFRS 16 approach, including the present value of the option's exercise price.
- The right-of-use asset is depreciated (amortised) over the asset's useful life, consistent with an expected transfer of ownership.
- Subsequently, the lessee recognises interest expense on the lease liability and amortisation of the right-of-use asset separately, rather than the single straight-line lease cost recognised for an operating lease.
If the option is not reasonably certain to be exercised, the exercise price is excluded from lease payments, and the lease is classified based on the remaining four criteria—it may well remain an operating lease.
Practical Example
Company X leases specialised manufacturing equipment for 5 years, with annual payments of $50,000 paid in arrears and a discount rate of 7%. The contract includes an option to purchase the equipment at the end of the lease for $10,000. The equipment's expected fair value at that date is $80,000, so the $10,000 price is a bargain purchase option—exercise is reasonably certain.
Measuring the lease liability:
- PV of 5 annual payments of $50,000 (annuity factor, 7%, 5 years ≈ 4.100): $205,000
- PV of the $10,000 purchase option (discount factor, 7%, 5 years ≈ 0.713): $7,130
- Total lease liability: $212,130
Under IFRS 16:
- The right-of-use asset is initially recognised at $212,130 (assuming no other adjustments).
- Dr Right-of-use asset $212,130 / Cr Lease liability $212,130
- Because ownership is reasonably certain to transfer, the right-of-use asset is depreciated over the equipment's useful life (say, 8 years), not the 5-year lease term.
Under ASC 842:
- The bargain purchase option meets the "reasonably certain to exercise" criterion, so the lease is classified as a finance lease.
- Initial measurement is identical to IFRS 16: $212,130 for both the lease liability and right-of-use asset.
- Subsequently, Company X recognises interest expense on the lease liability (effective interest method) and amortisation of the right-of-use asset over 8 years as two separate expense line items, rather than a single straight-line lease cost.
If the purchase price were instead $75,000—close to the expected fair value, with no other factors pointing to reasonable certainty—the option would not be reasonably certain to be exercised. The exercise price would be excluded from the lease liability under both standards, and under ASC 842 the lease could remain an operating lease. Under IFRS 16, the lease would still be disqualified from the short-term lease exemption purely because it contains a purchase option, even though exercise is not reasonably certain.
Classifying purchase options manually?
Leash automatically measures lease liabilities and right-of-use assets—including purchase options—and applies the correct IFRS 16 or ASC 842 treatment.
Disclosure Considerations
Both standards require entities to disclose the significant judgements made in assessing purchase options:
- IFRS 16 requires disclosure of information about extension, termination, and purchase options as part of its qualitative lease disclosures, along with the judgements applied in determining whether exercise is reasonably certain.
- ASC 842 similarly requires disclosure of significant assumptions and judgements made in determining whether a lessee is reasonably certain to exercise an option to purchase the underlying asset.
Entities should document the specific facts and circumstances supporting a reasonably certain conclusion at commencement, since this judgement is not revisited unless a qualifying triggering event occurs.
Conclusion
A purchase option is easy to overlook in a lease contract, but the accounting consequences are significant. Under IFRS 16, a reasonably certain purchase option changes the lease term, the lease liability, and the depreciation basis of the right-of-use asset. Under ASC 842, the same option can determine whether a lease is classified as operating or finance in the first place—directly shaping how lease expense appears in profit or loss.
Getting the "reasonably certain" assessment right, and documenting it properly, is therefore just as important as the arithmetic that follows from it.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.