Finance Lease Criteria under US GAAP: A Comprehensive Guide

A finance lease is an important tool for businesses to obtain access to property and assets. It is governed by specific criteria that must be met to classify a lease as a finance lease under US Generally Accepted Accounting Principles (GAAP). In this guide, we will explore the key criteria for finance lease classification and provide a comprehensive understanding of the topic.

Understanding Finance Lease Classification

Before diving into the specific criteria, let's first understand what finance lease classification entails. A finance lease is a type of lease that transfers substantially all the risks and rewards of ownership to the lessee. It is characterized by long-term usage and ownership-like control over the leased asset.

Now, let's explore the five criteria that govern finance lease classification under US GAAP:

1. Bargain Purchase Option

   A bargain purchase option is a provision in the lease agreement that allows the lessee to purchase the leased asset at a price significantly below its fair value. If the lease agreement includes a bargain purchase option and the lessee is reasonably certain to exercise it, the lease is classified as a finance lease.

2. 90% Test

   The 90% test is a criterion that evaluates the present value of lease payments compared to the fair value of the leased asset. If the present value of lease payments exceeds 90% of the fair value of the leased asset, the lease is classified as a finance lease.

3. Alternative Use

   If the leased asset has no alternative use to the lessor at the end of the lease term, it indicates that the lessee is effectively taking on the risks and rewards of ownership. This criterion is considered in determining whether a lease is a finance lease.

4. Depreciable Life

   The depreciable life of the leased asset is another criterion for finance lease classification. If the lease term encompasses a major part of the asset's economic life, it suggests that the lessee is essentially assuming ownership of the asset and the lease is classified as a finance lease.

5. Collectibility

   The collectibility criterion evaluates the likelihood of the lessor collecting the lease payments from the lessee. If collection of lease payments is reasonably certain, it indicates that the lessee has taken on the risks and rewards of ownership, resulting in the lease being classified as a finance lease.

Additional Considerations for Finance Lease Classification

In addition to the five criteria mentioned above, there are several other factors that may influence finance lease classification under US GAAP. These include:

• Collateral provided by the lessee
• Existence of contingent rents
• Contract consideration and day 1 loss
• Default covenants and provisions
• Economic incentives and penalties
• Fair market value and fair value of leased asset
• Finance lease vs. operating lease determination
• Lease payment tests
• Lease term and leasehold improvements
• Lessors and lessor classification
• Loan guarantees and loans to lessor
• Master leases and portfolio approach
• Non-cancellable lease terms and renewal options
• Purchase options and transfer of ownership
• Residual value guarantees and insurance
• Termination options and protective rights

It's important to consider these additional factors in conjunction with the five primary criteria to accurately classify a lease as a finance lease under US GAAP.

Conclusion

In conclusion, finance lease classification under US GAAP is governed by five key criteria: bargain purchase option, 90% test, alternative use, depreciable life, and collectibility. These criteria, along with additional considerations, help determine whether a lease should be classified as a finance lease. By understanding and applying these criteria, businesses can ensure accurate financial reporting and compliance with US GAAP guidelines.