What is a capital/finance lease?
A capital lease, referred to as a finance lease under ASC 842 and IFRS 16, is a lease that has the characteristics of an owned asset. In accounting, for a capital lease, the lessee records the leased asset as if he or she purchased the leased asset using funding provided by the lessor.
As a refresher, an operating lease functions much like a traditional lease, where the lessee pays to use an asset but doesn’t enjoy any of the ownership economic benefits nor incur any of the risks that come with ownership.
Finance lease vs. capital lease
Why will capital leases now be referred to as finance leases? This is one of the biggest changes between the old and new lease accounting standards. The reasoning behind this change is simple; because the majority of leases will now be “capitalized” (with the exception of those with a term equal to or less than 12 months), the existing nomenclature of “capital lease” is no longer accurate. Hence, the new term, “finance lease.”
The following is an excerpt from ASC 842: Definition of a Lease:
Under the lessee accounting model in previous GAAP, the critical determination was whether a lease was a capital lease or an operating lease because lease assets and lease liabilities were recognized only for capital leases. Under Topic 842, the critical determination is whether a contract is or contains a lease because lessees are required to recognize lease assets and lease liabilities for all leases— finance and operating—other than short-term leases (that is, if the entity elects the short-term lease recognition and measurement exemption). Topic 842 provides detailed guidance and several examples to illustrate the application of the definition of a lease to assist entities in making this critical determination.
Capital lease criteria: under ASC 840
Under ASC 840-25-1, there are 4 tests that determine whether a lease is a capital lease or an operating lease. This assessment is to be performed when the lease is signed. Many companies are familiar with these 4 tests so we have summarized them below.
- 1st test – Does the title/ownership transfer to the lessee at the end of the lease term?
- 2nd test – Is there a bargain purchase option?
- 3rd test – Is the lease term 75% or more of the remaining economic life of the asset?
- 4th test – Does the present value of the sum of the lease payments exceed 90% or more of the fair value of the underlying asset?
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ASC 842 provides a practical expedient that, upon transition, allows a company to grandfather the lease classifications for leases that began pre-transition. The FASB has indicated that companies electing this practical expedient must ensure that the accounting under ASC 840 is appropriate, as this expedient was not intended to allow a company to grandfather accounting errors. Therefore, while ASC 842 is upon us, it is important that the lessee has a firm grasp of their lease classifications under ASC 840.
“Strong-form” vs. “weak-form” finance leases
Here at LeaseQuery, we like to call finance leases that meet either the 1st or 2nd criterion “strong-form” finance leases and those that meet only the 3rd or 4th criterion “weak-form” finance leases.
This is an important distinction because there is one major difference between those types of leases. For finance leases that transfer ownership at the end of the lease term or those that have a bargain purchase option (strong-form finance leases), the underlying assets are depreciated over the useful life that would be assigned if the asset were owned.
For weak-form finance leases (those that meet only the 3rd or 4th criterion), the assets would be depreciated over the shorter of the useful life or the lease term. This is a subtle difference, but it obviously has profound accounting implications.
Finance lease criteria: how classification has changed under ASC 842
There isn’t much of a change in the way finance leases are treated for lessees. What’s most significant is that there are now five tests you must complete to determine the lease classification, instead of four. Another distinction is that the lease classification is performed at lease commencement under ASC 842, instead of when a lease is signed.
ASC 842-10-25-2 provides the lease classification criteria for lessees:
“A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.”
Now, let’s walk through each test and understand some of the distinctions between ASC 840 and ASC 842.
- 1st test – Does the title/ownership of the underlying asset transfer to the lessee at the end of the lease term?
This test is consistent under ASC 840 and ASC 842.
- 2nd test under 842 – Does a purchase option exists and is the lessee reasonably certain to exercise the option to purchase?
In contrast to ASC 840, under ASC 842, the existence of a bargain purchase option does NOT automatically classify a lease arrangement as a finance lease.
Instead, under ASC 842, the criteria is focused on the lesse’s determination (using economic factors) of its likelihood to exercise a purchase option within the agreement. The economic factors used to evaluate this purchase option could include consideration of a bargain purchase option.
- 3rd test – Is the lease term commensurate with the major part of the remaining economic life of the asset?
- 4th test – Is the present value of the sum of the lease payments equal or exceed substantially all of the fair value of the underlying asset?
The bright lines (specific thresholds) for the 3rd and 4th tests have been removed under ASC 842. “Major part” and “substantially all” are not defined under ASC 842, however, ASC 842-10-55-2 provides guidance that the 75% threshold for remaining economic life of the underlying asset represents a major part and 90% threshold represents substantially all of the fair value of the underlying asset. It’s important to determine your company’s internal policy of what the threshold will be for those tests, document it, and follow it consistently. In our experience, almost all of LeaseQuery’s clients have chosen to keep the existing thresholds of 75% and 90% for continuity purposes.
- New 5th test – Is the asset so specialized in nature that it provides no alternative use to the lessor once the lease is complete?
The 5th test was added in ASC 842. However, typically, we notice that if a lease triggers the 5th test, that it also likely had triggered one of the other “weak form” tests. This is because, for example, a shrewd landlord would factor in the future use for the asset when establishing the lease payments, and as such, typically the 4th test would be triggered.
Finance lease accounting example for a lessee
Now that we’ve had our refresher, let us address finance lease accounting under ASC 842 using an example.
Assume a company (lessee) signs a lease for a forklift with the following predicates:
- Fair value of the forklift is $16,000
- Lease term is 3 years
- Monthly payments of $500/month paid in advance; $50 of the monthly payment is related to maintenance
- Interest rate a bank would charge this company for a $16,000 loan over 3 years is 4%
- Useful life of the forklift is 5 years
- At the end of the lease term, the company can purchase the forklift for $1,000, which is the estimated fair value at the end of the lease.
Determining finance lease vs. operating lease under ASC 842
How do you determine if the lease is a finance lease or an operating lease? A company would need to perform the finance versus operating lease test, which is composed of five parts under topic 842. If the lease meets any of the following five criteria, then it is a finance lease.
Criteria 1: There is a title transfer at the end of the lease term
There is no title transfer at lease end, so the first test for finance lease accounting is not met.
Criteria 2: The lease agreement includes a purchase option that the lessee is reasonably certain to exercise. The lessee also does not plan to exercise the purchase option, so the second test for finance lease accounting is not met.
Criteria 3: The lease term is greater than or equal to the major part of the useful life of the asset. (Note: This company has maintained the greater than or equal to 75% threshold for this test).
The lease term is 3 years while the useful life is 5 years. 3 years is less than 75% of 5 years (3 versus 3.75), so the third test for finance lease accounting is not met.
Criteria 4: The present value of the sum of the lease payments is substantially all of the fair value of the leased asset. (Note: This company has maintained the greater than or equal to 90% threshold for this test).
Criteria 5: The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
The fifth test is not applicable to this lease.
In order to perform the fourth test, we need to calculate the present value of the minimum lease payments. This is calculated as the present value of monthly payments of $450 over 3 years at 4%. Why are we using $450 instead of the full monthly payment of $500? Well, the $50 related to maintenance is deemed a non-lease component under ASC 842. The lessee should only be accounting for the portion of the payments that relate to the lease component when accounting for the lease arrangement. (Note: While the terminology has changed, the overall treatment for maintenance is consistent with accounting under ASC 840, whereby the maintenance was considered an executory cost, and therefore is not considered part of the minimum lease payments, and was therefore excluded from the present value calculation.)
Download our free present value tool that performs the present value calculation for you. (For reference, we also have a blog that illustrates how to use Excel to calculate the present value of lease payments). Using this tool, we calculate a present value of $15,292.65, which is greater than 90% of the fair value of the asset (90% of $16,000 is $14,400). This lessee has chosen to utilize the 90% threshold to represent “substantially all” of the fair value of the asset. As a result, this lease is classified as a finance lease per the fourth test, and as such finance lease accounting needs to be applied.
The following schedule is an image of the lease amortization schedule used to record the journal entries under finance lease accounting:
How to record a finance lease
We now have all the information we need to record the initial journal entry: As documented above, the present value of the minimum lease payments is $15,292.65; so the initial journal entry to record the finance lease at least commencement is:
|Finance Lease Asset||15,292.65|
|Finance Lease Liability||15,292.65|
In the first month, two entries need to be recorded; one to record the payment of the lease, and the second to record depreciation expense.
The following entries would be recorded during month-end close of the first month:
A portion of the payment the lessee makes goes against interest expense, a portion relates to the non-lease element of maintenance costs, while the remaining balance goes to reduce the finance lease liability. These numbers are easily obtained from the amortization schedule above.
|Finance Lease Liability||401.20|
Because this is a “weak-form” lease, it is depreciated over the lease term of 3 years (36 months). The following journal entry represents the entry for depreciation expense, which will not change throughout the lease:
Journal entries in subsequent months will be similar to the first month entry, in that the payment will be allocated between lease liability, interest expense, and maintenance expense and depreciation expense will be recognized.
If you enjoyed reading this blog, please read our blog comparing finance leases and operating leases under ASC 842, GASB 87, and IFRS 16.