Accounting Standards Update No. 2016-02, Leases and Subsequent Updates (Topic 842), classifies leases into finance leases and operating leases. The major distinction is that a finance lease, in essence, represents the purchase of the underlying asset by the lessee directing the asset’s use and receiving its economic benefits in exchange for lease payments.
Defining Finance Lease vs. Operating Lease
Under Topic 842, a lease is deemed to be a finance lease if any of the following criteria are met:
Ownership of the underlying asset transfers to the lessee at the end of the lease term.
The lease includes a purchase option, and the option is reasonably certain to be exercised by the lessee. The phrase reasonably certain reflects a high threshold of probability and has a greater likelihood of occurrence than the term probable. Probable is not defined under US GAAP but is commonly thought of as over 75% likelihood of the event occurring.
The lease term is for the majority of the remaining economic life of the underlying asset, even if ownership does not pass to lessee at the end of the lease term. If the lease commencement date is near the end of the economic life of the underlying asset, then this criterion should not be used for lease classification purposes.
The present value of future lease payments, plus any residual value guaranteed by the lessee, equals or exceeds substantially all of the fair value of the underlying asset.
The underlying asset is of such a specialized nature that it would have no alternative use by the lessor at the end of the lease. This is a new classification criterion added under Topic 842. This criterion was added as the lessor would not be able to re-lease or sell the underlying asset without major modifications at the end of the lease term, which represents the economic benefit of the asset being transferred to the lessee over the lease term.
If none of these conditions are met, the lease is classified as an operating lease.
With the exception of the specialized nature criterion, the conditions for finance lease classification under Topic 842 are similar to legacy US GAAP, Topic 840. It is important to note that Topic 840 included bright-line rules with specific percentages and numerical values in the capital lease classification conditions. On the other hand, Topic 842 is principles-based and requires analysis and judgement of economic incentives and lease conditions.
Within the implementation guidance in Topic 842, FASB lays out one reasonable approach to determine if there is a finance lease based on the economic life or fair value criteria. One of the following conditions must be met:
- The lease term is equal to 75% or more of the remaining economic life of the underlying asset.
- The present value of future lease payments, plus any residual value guaranteed by the lessee, equals 90% or more of the fair value of the underlying asset.
Change in Classification
Lease classification is not reassessed after the commencement date unless the lease contract is modified. Thus, the lessee should reassess the classification if there is a change in the assessment of the lease term or if the lessee becomes reasonably certain to exercise a purchase option in the lease contract.
If the classification is required to be reassessed, the facts and circumstances as of the date of reassessment should be considered, including the modified terms or conditions. For example, the fair value and remaining economic life would be calculated as of the reassessment date.
Finance lease is a new term in Topic 842; however, these types of leases are similar to capital leases under Topic 840, both in form and in the accounting recognition. Like Topic 840, a lessee recognizes a lease asset and liability on the balance sheet equal to the present value of future lease payments. Under Topic 842, this is referred to as the right of use asset as it represents the lessee’s right to direct the asset’s use over the lease term.
On the income statement, lessees will recognize the amortization expense—amortization of right to use asset—and the interest expense related to the finance lease. These expenses are excluded from earnings before interest, taxes, depreciation, and amortization (EBITDA). On cash flow statements, lessees will include the interest component of lease payments in cash flows from operating activities. They will also include the non-interest component of lease payments in cash flows from financing activities.
The terminology for operating leases in Topic 842 remains the same as in Topic 840. However, under Topic 842 there is a significant change in the balance sheet presentation for operating leases. Lessees must recognize a right of use asset and lease liability on the balance sheet for the term of the lease. The right of use asset and lease liability for operating leases must be broken out separately on the balance sheet from finance leases.
The income statement and statement of cash flow presentation for operating leases remains unchanged under Topic 842. Lessees continue to recognize the straight-lined lease expense over the term of the lease in the operating section of the income statement. Lease payments are included in cash flows from operating activities on the statement of cash flows.
If you have questions regarding the new lease standard, or you need assistance implementing it for your organization, please send us an email.
Author Kate Kohlwes is a manager in Clark Nuber’s Audit and Assurance Services Group.
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