A lease contract can be classified as an operating or finance lease. In some cases, both parties can recognize a lease contract as a direct finance lease as well.
US GAAP rules ASC 842 – Leases define five criteria test points to evaluate a lease contract classification.
It’s important to note that both the lessor and the lessee will have to make an assessment separately. However, in most cases, their assessment of a lease contract should be the same.
Let us analyze the classification criteria of a lease contract as an operating v finance lease.
Classification of a Lease Contract
The US GAAP rules ASC-842: Leases provides these five points to assess a lease contract for classification purpose.
A lease contract shall be classified as a finance lease if it meets one of the following five test points.
- The ownership of the underlying asset will be transferred to the lessee at the end of the lease contract.
- The lessee has the option to purchase the underlying asset.
- The lease contract is for the major part of the useful life of the asset.
- The lease payments’ present value and any guaranteed residual value is substantially equal to or greater than the fair market value of the asset.
- The underlying asset is specialized to the use of the lessee only.
If the lease contract does not fulfill any of these five points, it will be recorded as an operating lease.
Further, the lessor will classify a financing lease as a direct financing lease if it fulfills these two additional points.
- If the lease payments’ present value and any residual value guaranteed (by the lessee or a third-party) is substantially equal to or greater than the fair value of the underlying asset.
- If it is probable that the lessor will receive any residual value payments guaranteed by the lessee.
5 Points of Lease Classification Criteria Test
Let us elaborate on the critical five points to determine a lease classification.
1. Transfer of Ownership
A lease contract shall be classified as a sales-type lease by the lessor and a financial lease by the lessee if the ownership of the underlying asset transfers to the lessee.
The ownership transfer takes place at the end of the lease contract usually. In some cases, the lessee also makes a payment for the cost of ownership transfer. The term is qualified in that situation as well.
The transfer of ownership under ASC 842 closely resembles ASC 606 for the transfer of title of an asset. The business entity can assess the legal transfer of title under ASC 606. However, it must then assess the criteria of actual transfer of ownership under ASC 842 to determine the classification.
2. Purchase Option
If the lease contract contains an option for the lessee to purchase the underlying asset, it fulfills the second criterion. The lessor and the lessee shall recognize the lease contract as a sales-type lease and a financial lease respectively in their account books.
The purchase option must come with a certain reasonable option for the lessee. Reasonability means the lessee gets a favorable price at the time of exercising the option.
Some economic conditions such as import restrictions, patents, or customization may also provide a reasonable option to the lessee for the purchase of the underlying asset.
Both parties should consider the purchase pricing options as well. The time at which the option is exercised and the pricing formula should be evaluated by both parties to determine whether the lessee has a considerable reason to exercise the option.
3. Lease Term
The lease term test evaluates whether the term of the lease is for the major part of the useful economic lifespan of the underlying asset or not. If the lease contract fulfills this criterion, the lessee effectively holds control of the asset.
ASC 842 does not define categorically the “major part” of the life of the asset. However, both parties can use an estimation of 75% of the economic useful life of the asset in continuation of previously applicable ASC 840.
The lease term includes any renewals or termination clauses of the lease contract. These clauses should be considered with the certainty of exercising options by both parties.
Both parties can determine the economic useful life as defined by ASC 842. An economic useful life is when an asset is economically usable by the lessee or other users. Or, if the asset is capable of producing a similar number of units in production.
4. Lease Payment
The lease payment criterion test is met if the present value of all lease payments and guaranteed residual value (already included in the lease contract or not) exceeds or equals substantially all of the market fair value of the underlying asset.
ASC 842 does not provide clear guidance on the judgment of the “substantially all” part of the market value of the asset. However, both parties can determine it in continuation with ASC 840 definition of 90% of the fair market value of the asset.
The lease payments will include these different types of payments as well:
- Fixed lease payments less any incentives or allowances offered by the lessor.
- Variable lease payments using different rates.
- Penalties for the early termination of the lease contract.
- Fees paid by the lessee for the transfer of ownership of the asset.
- The exercise price of a purchase option to the lessee with reasonable certainty.
5. Specialized Nature of the Leased Asset
The fifth criterion relates to the specialized nature of assets. These are the assets that the lessor offers specifically to fulfill the needs of the lessee.
If the underlying asset has no alternative use for the lessor at the end of the lease contract, it shall be classified as a financial lease or a sales-type lease by the lessor.
The evaluation of the specialized nature can be assessed through the sale option or leasing to another party by the lessor. The specialized nature would also include assessments including any patent rights, economic restrictions, and contractual restrictions to the lessor.