Understanding the Financial Lease Criteria RJ: A Comprehensive Guide

Lease classification is governed by five criteria that help determine whether a lease should be classified as a finance lease or an operating lease. These criteria include the bargain purchase option, the 25% test, the 90% test, alternative use, and classification exemption.

The bargain purchase option is one of the criteria used to determine the classification of a lease. It refers to an option that allows the lessee to purchase the leased asset at a price significantly lower than its fair market value. If a lease includes a bargain purchase option, it is likely to be classified as a finance lease.

The 25% test is another important criterion in lease classification. It examines whether the lease term is equal to or greater than 75% of the estimated economic life of the leased asset. If the lease term meets or exceeds the 75% threshold, the lease is likely to be classified as a finance lease.

Similarly, the 90% test evaluates whether the present value of the lease payments, plus the residual value guarantee, amounts to at least 90% of the fair value of the leased asset. If the lease satisfies this test, it is likely to be classified as a finance lease.

The alternative use criterion considers whether the leased asset has an alternative use to the lessor at the end of the lease term. If the lessor has a substantive alternative use for the asset, the lease is more likely to be classified as a finance lease.

Lastly, the classification exemption criterion allows certain leases to be exempt from lease classification requirements. This exemption applies to leases of assets with low-value or short-term leases, as defined by the lease accounting standards.

It is important to note that the lease classification criteria may vary depending on the applicable lease accounting standard, such as ASC 842 or IFRS 16. Reporting entities should carefully evaluate the criteria specified in the relevant accounting standard to determine the classification of their leases.

Examples of Lease Classification Criteria in Practice

To better understand how the lease classification criteria work, let's take a look at some examples:

Example 1: Bargain Purchase Option

Company A leases a piece of equipment with a lease term of five years. At the end of the lease term, Company A has the option to purchase the equipment for $1,000, significantly below its fair market value of $10,000. In this case, the lease includes a bargain purchase option, indicating that it is likely to be classified as a finance lease.

Example 2: 25% Test

Company B leases a vehicle with an estimated economic life of eight years. The lease term is six years, which is equal to or greater than 75% of the estimated economic life. As a result, the lease meets the 25% test and is likely to be classified as a finance lease.

Example 3: 90% Test

Company C leases a building with a fair value of $1,000,000. The present value of the lease payments, plus the residual value guarantee, amounts to $900,000, which is at least 90% of the fair value of the building. The lease satisfies the 90% test and is likely to be classified as a finance lease.

Example 4: Alternative Use

Company D leases specialized manufacturing equipment to Company E. At the end of the lease term, Company D has no alternative use for the equipment and intends to sell it on the open market. In this case, the lessor does not have a substantive alternative use for the asset, indicating that the lease is more likely to be classified as a finance lease.

Example 5: Classification Exemption

Company F leases office furniture for a period of three months. The lease falls within the short-term lease exemption, which allows it to be exempt from lease classification requirements. As a result, the lease does not need to be classified as either a finance lease or an operating lease.

Conclusion

Understanding the financial lease criteria is crucial for reporting entities to properly classify their leases. The bargain purchase option, 25% test, 90% test, alternative use, and classification exemption are key factors in determining whether a lease should be classified as a finance lease or an operating lease. By evaluating these criteria, reporting entities can ensure compliance with the applicable lease accounting standards and accurately represent the nature of their lease agreements.