The classification of a lease dictates the accounting treatment for both lessees and lessors. Under US GAAP, public and nonpublic entities follow a two-model approach for the classification of lessee leases. Leases are deemed either capital/finance or operating based on set criteria.

Capital/finance vs. operating lease criteria

ASC 840, the previous lease accounting standard, outlines four criteria for identifying the lease classification. If a lease agreement contains at least one of the criteria, the lease should be classified as a capital lease from the lessee’s perspective.

Moving forward, with the adoption of ASC 842, a lease agreement is classified based on five criteria (ASC 842-10-25-2). Similarly, if one of the five criteria is met, then lessees should classify the lease as finance.

One of the changes implemented with the new lease accounting standards is the renaming of capital leases to finance leases. While this is mostly a nomenclature change to provide more clarity to the different types of lease commitments, key differences in how a lease is classified under ASC 840 vs. ASC 842 do exist.

Let’s take a look at the differences in criteria below.

Transfer of title/ownership to the lessee

Criteria: Transfer of ownership occurs by the end of the lease term. This is commonly seen in equipment or vehicle leases where at the conclusion of the lease term, the lessor relinquishes title to the asset and ownership of the asset transfers to the lessee.

This criterion is the same from ASC 840 to ASC 842.

Exercising a purchase option

Criteria: The lease agreement contains a provision where the lessee has the option to purchase the asset, and that option is reasonably certain to be exercised. This is slightly different from previous guidance where the mere presence of a bargain purchase option would indicate a capital lease. Note: A bargain purchase option under ASC 840 was defined as a purchase price significantly lower than the expected fair value of the asset or penalties realized due to the asset’s specialized use.

To determine whether the option is reasonably certain to be exercised, the lessee should consider the following factors:

  1. Contract-based
    • Evaluate pricing for purchase option
    • Evaluate the duration of the lease term and other options
  2. Asset-based
    • Determine the cost of returning the asset to the lessor
    • Consider relocation
    • Evaluate significant leasehold improvements, etc.
  3. Market-based
    • Determine the market price for comparable assets
    • Consider laws and regulations
  4. Entity-based
    • Determine the significance of the asset to the lessee’s operations (i.e., specialized use)
    • Define tax consequences
    • Evaluate the financial impact of purchasing the asset, etc.

Of course, judgment is required when assessing whether an option is reasonably certain. For additional support, please refer to ASC 842-10-55-26.

Lease term

Criteria: The lease term represents the major part of the asset’s economic life. Companies must now make judgmental assessments that can often vary by class of asset. This is one of the stark differences with the adoption of the new lease standard. The “bright line” or specific threshold for this test is removed under ASC 842. ASC 840 defines a specific threshold of at least 75% of the asset’s remaining economic life. However, ASC 842 does not indicate a specific percentage, but rather requires more judgment.

“Major part” is not defined under ASC 842; however, ASC 842-10-55-2 provides guidance that an organization can continue to use the 75% threshold, used in ASC 840, for remaining economic life of the underlying asset to define a major part of the asset. For example, if your organization established an internal policy to use 10 years for the useful life of its forklifts and the organization signs an eight year lease agreement, this lease may be classified as finance (8 years / 10-year useful life = 80%).

In addition, if a lease commences “at or near the end” of the asset’s economic life, the lease term criterion is not used and the lease classification conclusion is based only on analysis of the other four factors. Once again, the guidance does not establish a “bright line” for determining when this exception should be used, but suggests that scoping out this criterion for leases that commence in the last 25% of an asset’s life is a reasonable approach.

Present value

Criteria: The present value of lease payments over the lease term, calculated at lease commencement, equals or exceeds substantially all of the fair value of the asset. When assessing lease payments under ASC 842, unlike ASC 840, if a portion of property taxes or insurance is considered a lease payment, then it should also be included for the purposes of the classification test. ASC 840 excludes fixed executory costs.

Similarly, as indicated above for the economic life criterion, ASC 842 removes the bright line of this test.

“Substantially all” is also not defined under ASC 842. However, this phrase is used throughout other guidance where a 90% threshold is implied. Furthermore, ASC 842-10-55-2 explains how companies can continue to use the 90% threshold under ASC 840 to define substantially all of the fair value of the underlying asset.

Note: It’s important to determine your organization’s internal policy for each threshold for the classification criteria, document it, and follow it consistently. In our experience, most companies choose to keep the existing thresholds of 75% and 90% for continuity purposes, as deviating from the bright lines will cause additional work and documentation to prove admissible.

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Alternative use

Criteria: The asset is so specialized in nature that it provides no alternative use to the lessor after the lease term.

While the first four criteria were present under ASC 840, the fifth and final criteria is new under ASC 842. Though we mentioned that a lease must meet a minimum of one of these five criteria to be considered a finance lease, we have often found that if a lease triggers this fifth test, it has also triggered one of the other four tests. This is because most landlords likely factor in the future use for the asset when establishing the lease payments. As such, the fourth test would be triggered too.

Capital/finance vs. operating lease impact on the business

Previously, operating leases were considered off-balance-sheet transactions. The new standard, ASC 842, requires operating leases to be recognized on the balance sheet. The rationale being it provides better representation of lessees’ obligations to investors, creditors, and other financial statement users.

With both capital/finance and operating leases now realizing a liability and asset, the total assets and liabilities recognized on the balance sheet are increased. No impact to debt occurs when transitioning to ASC 842. However, companies should consider how the new operating liability could potentially impact certain financial ratios.

Let’s also consider the income statement impact. The classification of a lease helps determine how and when the lessee recognizes expense. No change to expense is recognized when transitioning from ASC 840 to ASC 842; therefore, the P&L statement remains consistent. Operating leases will continue to recognize rent expense and capital/finance leases will recognize both interest expense and depreciation expense.

Effectively, no impact to the P&L also means no impact to EBITDA. However, situations may occur where leases classified as operating under ASC 840 may be considered finance leases under ASC 842 as a result of the additional classification criteria. Please note the package of practical expedients to evaluate the relief efforts at transition.

Summary

The classification of an operating lease versus a finance lease under the new guidance is determined by evaluating whether any of the finance lease criteria are present. If a lease agreement contains at least one out of the five criteria, it should be classified as a finance lease.

A significant aspect of the new standard is that both operating leases and finance leases must be recorded on a company’s balance sheet, whereas only capital leases were previously recorded on the balance sheet.

Understanding how a lease is classified, the key differences from ASC 840 to ASC 842, and its impact to the business will equip your company for success in the adoption of the new lease accounting standard.

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