Bargain Renewal Option

Bargain renewal option is a clause in a lease agreement that gives the lessee the option to renew or extend the original lease on an asset at rates well below market rates. The inclusion of such a clause would require the lessee to classify the lease as a capital lease rather than an operating lease.

Presently, under ASC 840-10 of the Financial Accounting Standard Board (FASB), a bargain renewal option is defined as: "A provision allowing the lessee, at his option, to renew the lease for a rental sufficiently lower than the fair rental of the property at the date the option becomes exercisable that exercise of the option appears, at lease inception, to be reasonably assured. Fair rental of a property in this context shall mean the expected rental for equivalent property under similar terms and conditions." 

A lease confers the right for a lessee to use an asset or property for a certain period of time. An operating lease does not convey the right of ownership at the end of the term. A capital lease, for accounting purposes, represents ownership of the asset from the beginning of the lease. Under current accounting rules, a bargain renewal option classifies the contractual arrangement as a capital lease instead of an operating lease. The accounting treatment is different for the two types. Basically, a lessee with a capital lease must book the value of this fixed asset on the balance sheet and record depreciation expense. An operating lease is "off-balance sheet" - the asset is not booked on the balance sheet and lease payments are expensed on the income statement.

In February 2016, the FASB revised rules governing lease accounting by requiring that all leases, except for short-term leases with terms less than one year, must be capitalized. The new rules become effective for fiscal periods beginning on December 15, 2018. Thus, the implication of a bargain renewal option for lease accounting will become moot as of this effective date.