Finance Lease Criteria under ASC 842: A Comprehensive Guide

The Importance of Finance Lease Criteria under ASC 842

Lease classification is governed by five criteria. These criteria play a crucial role in determining whether a lease should be classified as a finance lease or an operating lease under ASC 842. Understanding these criteria is essential for businesses to comply with the new lease accounting standards.

1. Bargain Purchase Option

A bargain purchase option is one of the key criteria for classifying a lease as a finance lease. If the lessee has the option to purchase the leased asset at a significantly lower price than its fair value at the end of the lease term, the lease is likely to be classified as a finance lease.

2. 25% Test

The 25% test examines whether the lease term covers a substantial portion of the asset's economic life. If the lease term is equal to or greater than 75% of the asset's economic life, the lease is likely to be classified as a finance lease.

3. 90% Test

The 90% test determines whether the present value of lease payments represents at least 90% of the fair value of the underlying asset. If the present value of lease payments exceeds 90% of the fair value, the lease is likely to be classified as a finance lease.

4. Alternative Use

The alternative use criterion assesses whether the leased asset has no alternative use to the lessor at the end of the lease term. If the lessor has no practical ability to lease the asset to another party, the lease is likely to be classified as a finance lease.

5. Classification Exemption

A lease can be exempt from classification if it meets certain exemption criteria. These criteria include leases with a lease term of 12 months or less and leases of low-value assets. However, even if a lease is exempt from classification, it must still be disclosed in the financial statements.

Complying with these finance lease criteria under ASC 842 is vital for accurate lease accounting and financial reporting. By properly classifying leases, businesses can provide users of financial statements with a clear understanding of their lease obligations and the impact on their financial position and performance.

Additional Considerations for Lease Classification

In addition to the five finance lease criteria discussed above, there are several other factors that businesses should consider when classifying leases under ASC 842:

• Collateral: The presence of collateral can indicate the intention to transfer ownership of the leased asset, potentially leading to a finance lease classification.
• Contingent Rents: Contingent rents that depend on factors such as the usage or sales of the leased asset can affect the classification of the lease.
• Contract Consideration: The total consideration in the lease contract, including fixed and variable lease payments, should be evaluated to determine the appropriate lease classification.

It is important to thoroughly assess these factors and consult with accounting professionals to ensure accurate and compliant lease classification under ASC 842.

Conclusion

Finance lease criteria under ASC 842 play a crucial role in determining the classification of leases. By considering factors such as bargain purchase options, the 25% test, the 90% test, alternative use, and classification exemptions, businesses can accurately classify leases as finance leases or operating leases. Compliance with these criteria is essential for proper lease accounting and financial reporting.