5 Criteria for Finance Lease: A Comprehensive Guide

Lease classification plays a crucial role in accounting for leases. It determines whether a lease should be classified as an operating lease or a finance lease. In this guide, we will explore the five criteria that govern the classification of a finance lease.

1. Bargain Purchase Option

A finance lease typically includes a bargain purchase option, which allows the lessee to purchase the leased asset at a price significantly lower than its fair market value. The presence of a bargain purchase option is a key indicator that a lease should be classified as a finance lease.

2. 25% Test

The 25% test is another criterion used to determine the classification of a lease. If the present value of lease payments, excluding executory costs, exceeds 25% of the fair value of the leased asset, the lease is classified as a finance lease.

3. 90% Test

The 90% test is similar to the 25% test but with a higher threshold. If the present value of lease payments, excluding executory costs, exceeds 90% of the fair value of the leased asset, the lease is classified as a finance lease.

4. Alternative Use

A lease is more likely to be classified as a finance lease if the lessor has no alternative use for the leased asset at the end of the lease term. This criterion takes into account the specialized nature of the leased asset and the lessor's intent to use it exclusively for the lease agreement.

5. Classification Exemption

In some cases, leases that do not meet the above criteria may still be classified as finance leases if they fall under certain exemption categories. These exemptions are provided by accounting standards and may vary depending on the jurisdiction.

Understanding these five criteria is essential for correctly classifying leases as finance leases. Proper classification ensures accurate financial reporting and compliance with accounting standards.