What Is a Lease Purchase? Lease-to-Own Accounting Under ASC 842

What is a lease purchase? It is a lease-to-own deal: you pay for an asset over a set term, and it becomes yours at the end. That happens either automatically or for a small buyout price. Under ASC 842, a lessee usually books it as a finance lease.

Automatic title transfer meets ASC 842-10-25-2(a). A buyout the lessee is reasonably certain to exercise meets 842-10-25-2(b). The lease liability includes the buyout price. The right-of-use (ROU) asset is amortized over the asset's full useful life, not the lease term.

This page covers the lessee side under US GAAP, for private and public companies. The term "lease-purchase" also appears in public-sector financing. That follows different standards and is outside this article.

What is a lease purchase agreement?

A lease purchase agreement is a contract to use an asset for a fixed term in exchange for regular payments. Ownership moves to the user at the end. Equipment dealers call it lease-to-own, rent-to-own or a $1 buyout lease. Trucks, machine tools, medical devices and IT hardware are common examples.

The ownership piece usually takes one of two forms:

• Automatic transfer. Title passes to you once the last payment clears. Some contracts add a small fixed fee to cover the paperwork.
• Purchase option. You may buy the asset at the end for a stated price, such as $1, $1,000 or a set percentage of cost. You can also walk away.

That difference matters for classification, as the next sections show. For how to pull these terms out of the contract, see our guide to key equipment lease terms.

Is a lease-to-own contract a lease or a purchase?

Start with ASC 842-10-15-3. A contract is or contains a lease if it "conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration." A typical lease purchase deal fits: the lessor owns the asset during the term, and you control its use.

Ownership passing at the end does not take the contract out of ASC 842. It changes the classification instead. The Grant Thornton guide cites paragraph BC71 of ASU 2016-02 on this point. Meeting the ownership or purchase option test "indicates that the economic substance of the transaction is akin to a sale of the underlying asset to the lessee."

The harder case is a deal where legal title passes to you on day one. PwC's Leases guide, section 3.3.1, notes that a finance lease can be hard to tell apart from a financed purchase. It takes the view that ASC 842 generally applies except when legal title transfers at the beginning of the arrangement.

The answer turns on the contract's facts, so document the analysis and agree it with your auditor. The rest of this page assumes the lessor holds title during the term.

Is a lease purchase a finance lease?

Yes, in almost every case. ASC 842-10-25-2 lists five criteria, and a lease that meets any one is a finance lease for the lessee. Two of them describe a lease purchase directly:

• ASC 842-10-25-2(a): the lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
• ASC 842-10-25-2(b): the lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

Read the buyout clause closely. Under ASC 842-10-55-5, a required nominal fee to transfer title still counts as a transfer of ownership. Under ASC 842-10-55-6, if you may choose not to pay the fee, the clause is a purchase option, "whether nominal or otherwise." It then falls under criterion (b).

Criterion (b) needs judgment. Deloitte's Roadmap on leases, section 8.3, says "reasonably certain" is "meant to be a high threshold." ASC 842-10-55-26 lists the factors to weigh: contract, asset, market and entity-based factors.

A $1,000 option on a machine expected to be worth $30,000 clears that bar easily. An option priced at expected fair value needs other evidence. Example 24 at ASC 842-10-55-218 finds one reasonably certain because the equipment is specialized and vital to operations.

For the other three criteria, see applying the right lease classification.

How does a lease purchase work on the books?

At commencement you record a lease liability and an ROU asset. The rules come from three paragraphs:

• Lease liability. ASC 842-20-30-1(a) measures it at "the present value of the lease payments not yet paid," discounted at the rate for the lease.
• Purchase option price. ASC 842-10-30-5(c) includes the exercise price of a purchase option in lease payments when you are reasonably certain to exercise it. So the buyout price goes into the liability.
• ROU asset. ASC 842-20-30-5 starts from the lease liability, then adds payments made at or before commencement and initial direct costs, and subtracts incentives received.

Watch the first payment. If it is due at signing, it is already paid at commencement, so it is not in the liability. It goes straight into the ROU asset instead.

After commencement, ASC 842-20-25-5 has you record amortization of the ROU asset and interest on the liability as separate costs. ASC 842-20-35-8 sets the amortization period.

Normally that period ends at the earlier of the end of the lease term and the end of the right-of-use asset's useful life. But if the lease transfers ownership, or the purchase option is reasonably certain, you amortize "to the end of the useful life of the underlying asset." That makes sense: you will keep the asset after the payments stop.

The discount rate is the rate implicit in the lease when it is readily determinable; otherwise, your incremental borrowing rate. A company that is not a public business entity may instead elect a risk-free rate, by class of underlying asset (ASC 842-20-30-3). For the borrowing rate, see how to calculate the incremental borrowing rate.

Worked example: a five-year lease-to-own machine

A manufacturer signs a lease purchase agreement for a machine. Every input is stated below, so you can check the arithmetic.

The lessee cannot readily determine the rate implicit in the lease. It does not know the lessor's initial direct costs or residual value estimate. So it uses its incremental borrowing rate (ASC 842-20-30-3).

The lessee may decline the buyout, so this is a purchase option under ASC 842-10-55-6. Paying $1,000 for a $30,000 machine is a strong economic incentive to exercise, which usually supports a conclusion that exercise is reasonably certain. The lessee reaches that conclusion, so the lease is a finance lease under ASC 842-10-25-2(b).

The 3.465106 factor is the present value of $1 a year for four years at 6%. Had the controller amortized over the 5-year term, annual amortization would have been $22,474.98. That would overstate expense in years 1 to 5 and leave nothing for years 6 to 8, when the company still uses the machine.

The liability then unwinds with interest at 6% on the opening balance:

Year 1 lease cost is $5,242.49 of interest plus $14,046.86 of amortization, or $19,289.35. The entries follow the pattern in our operating vs. finance lease journal entries comparison.

How does a lease purchase compare with an operating lease or a bank loan?

Here is the same machine under three structures, from the lessee's side:

In practice, the lease purchase and the bank loan land in a similar place on the income statement: front-loaded interest and cost spread over the asset's life. The operating lease is the outlier, with one flat cost for the term.

What if the plan to exercise the buyout changes?

You set classification at commencement and do not revisit it every quarter. But ASC 842-10-25-1 requires a lessee to reassess classification if the lease term changes or its assessment of whether it is reasonably certain to exercise a purchase option changes.

Suppose a significant event or change in circumstances within your control means you are no longer reasonably certain to buy the machine. Disposing of the production line it serves is one example. You then reassess the purchase option, remeasure the lease liability and reassess classification (ASC 842-10-35-1, 842-20-35-4 and 842-10-25-1).

A change of mind alone is not a trigger, because no event within your control has occurred (ASC 842-10-35-1(a); see Deloitte's Roadmap: Leases, section 5.4). A change in market prices does not trigger reassessment in isolation either (ASC 842-10-55-29). See accounting for lease term changes for how remeasurement flows through the ROU asset.

For broader background on how lease accounting fits together, start with lease accounting explained. For more finance lease entries, see ASC 842 journal entries explained with examples.

Frequently asked questions

Is a lease purchase the same as a rent-to-own agreement?

For a business asset, yes in substance. Both describe payments over a term that end with the lessee owning the asset, either automatically or through a purchase option. The label does not drive the accounting. The contract terms do: title transfer under ASC 842-10-25-2(a), or a purchase option the lessee is reasonably certain to exercise under ASC 842-10-25-2(b).

Does a $1 buyout make a lease a finance lease?

Usually, but check the wording. If the contract requires the lessee to pay a nominal fee to complete the title transfer, ASC 842-10-55-5 treats it as a transfer of ownership. If the lessee may choose not to pay, ASC 842-10-55-6 treats it as a purchase option. A $1 option on a valuable asset is normally reasonably certain to be exercised, which meets ASC 842-10-25-2(b).

Is the purchase option price included in the lease liability?

Yes, when the lessee is reasonably certain to exercise the option. ASC 842-10-30-5(c) lists the exercise price of that option as a lease payment. It is discounted and included in the lease liability with the other payments not yet paid. An option that is not reasonably certain stays out of the liability.

Sources and further reading

• ASC 842-10-15-3 — definition of a lease.
• ASC 842-10-25-1 and 842-10-25-2 — classification at commencement, reassessment, and the finance lease criteria.
• ASC 842-10-35-1, 842-20-35-4 and 842-10-55-28 to 55-29 — when a lessee reassesses a purchase option; see Deloitte Roadmap: Leases, section 5.4.
• ASC 842-10-55-4 through 55-6 and 842-10-55-26 — transfer of ownership, nominal fees, purchase options, and the reasonably certain factors.
• ASC 842-10-30-5, 842-20-30-1 and 842-20-30-5 — lease payments and initial measurement of the lease liability and ROU asset.
• ASC 842-20-25-5, 842-20-25-6 and 842-20-35-8 — finance and operating lease cost, and the amortization period.
• Grant Thornton, Leases: Navigating the guidance in ASC 842 — lease classification criteria and the BC71 discussion of purchase options.
• Deloitte Roadmap: Leases, section 8.3, Lease classification.
• PwC Leases guide, section 3.3, Lease classification criteria — nominal fees and purchase options.

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