Understanding Financing Lease Criteria: A Comprehensive Guide

A financing lease is a type of lease arrangement in which the lessee assumes many of the risks and rewards of ownership. It is important for both lessors and lessees to understand the criteria that govern the classification of leases as financing leases. In this guide, we will explore the key criteria that determine whether a lease should be classified as a financing lease or an operating lease.

Key Lease Classification Criteria

Lease classification is governed by five key criteria:

• Bargain purchase option
• 25% test
• 90% test
• Alternative use
• Classification exemption

Bargain Purchase Option

A lease is classified as a financing lease if it includes a bargain purchase option. A bargain purchase option allows the lessee to purchase the leased asset at a price significantly lower than its fair market value. This indicates that the lessee is likely to exercise the purchase option and assume the risks and rewards of ownership.

25% Test

The 25% test is another criterion used to classify leases. If the present value of lease payments, excluding executory costs, exceeds 25% of the fair value of the underlying asset, the lease is considered a financing lease. This criterion reflects the extent to which the lessee is financing the acquisition of the asset through lease payments.

90% Test

The 90% test is similar to the 25% test, but it uses a higher threshold. If the present value of lease payments, excluding executory costs, exceeds 90% of the fair value of the underlying asset, the lease is classified as a financing lease. This criterion indicates a higher degree of financing by the lessee.

Alternative Use

If the leased asset has no alternative use to the lessor at the end of the lease term, the lease is classified as a financing lease. This criterion recognizes that the lessor has effectively transferred the risks and rewards of ownership to the lessee.

Classification Exemption

There are certain exemptions to lease classification criteria. For example, leases of land are exempt from classification criteria. Other exemptions include leases of assets with a lease term of 12 months or less and leases of assets with a total cost of $5,000 or less.

Additional Considerations

In addition to the key classification criteria, there are other factors that may influence the classification of a lease. These factors include:

• Collateral
• Collection
• Contingent rents
• Contract consideration
• Day 1 loss
• Default covenant
• Default provisions
• Depreciable life
• Direct financing lease
• Dismantle cost
• Early termination
• Economic incentive
• Economic life
• Major part
• Economic penalty
• Fair market value
• Fair value of leased asset
• Finance lease
• Financed purchase
• Fiscal funding clause
• Fixed price purchase option
• IBR
• In substance fixed lease payments
• Incremental borrowing rate
• Index or rate
• Land lease
• Lease payment
• Lease payments criterion
• Lease payment tests
• Lease portfolio
• Lease term
• Leasehold improvements
• Lessee asset
• Lessor
• Lessor asset
• Lessor classification
• Lessor cost
• Lessor exception
• Lessor fair value
• Loan guarantee
• Loans to lessor
• Master lease
• Negative discount rate
• New asset
• Non-monetary consideration
• Non-cancellable lease term
• Nonconsecutive lease term
• Operating lease
• Payments for non-performance
• Penalty for lease cancellation
• Perpetual leases
• Pooled residual value guarantee
• Portfolio approach
• Portfolio discount rate
• Predominant asset
• Private company consideration
• Private company practical expedient
• Probable
• Protective rights
• Rate implicit in the lease
• Real estate taxes
• Reasonably certain
• Reimbursement
• Removal costs
• Renewal option
• Residual value insurance
• Risk-free rate
• RVG
• Sales tax
• Sales-type lease
• Termination option
• Third-party residual value guarantee
• Title transfer
• Transfer of ownership
• Purchase options
• Lease term test
• Determining the term of the lease
• Determining the estimated economic life
• Fixed lease payments
• Lease incentives
• Variable lease payments
• Fair value of the underlying asset
• Collectibility
• Underlying asset is of a specialized nature
• ARO

Conclusion

Understanding the criteria for financing lease classification is essential for both lessors and lessees. By considering factors such as bargain purchase options, the 25% test, the 90% test, alternative use, and classification exemptions, parties can accurately classify leases and understand the risks and rewards involved in lease arrangements.