One of the changes that was implemented with the new lease accounting standards is the renaming of capital leases to finance leases. While this is mostly a change in name only, a significant aspect of the new standard is the addition of the balances related to operating leases to the financial statements. If you are unclear about the changes to the lease accounting guidance, this can set you up for non-compliance under the new rules. Armed with the information below, your company, as a lessee, can properly account for your leases and ensure your balance sheet is correct.
What is lease classification?
Under ASC 842, there are still two types of leases that must be accounted for – operating and finance (formerly capital). In contrast, IFRS 16 and GASB 87 do not have a distinction between types of leases. These standards follow a single model, now accounted for as finance leases.
Operating vs finance leases under ASC 842
Under ASC 842, the new U.S. GAAP lease accounting standard, both operating leases and finance leases must be recorded on a company’s balance sheet (previously only capital, i.e. finance, leases were recorded).
Under ASC 840, the previous lease accounting standard, operating leases were considered off-balance sheet transactions. The new standard, ASC 842, requires operating leases to be recognized on the balance sheet. The rationale was that this would give a better presentation of the lessee’s obligations to an investor.
Per the new lease accounting standard, classification of an operating lease versus a finance lease is determined by evaluating an arrangement to determine if any of the finance lease criteria are present. If a lease agreement contains at least one out of the five following criteria, it should be classified as a finance lease:
Transference of title/ownership to the lessee
Transfer of ownership occurs by the end of the lease term. An example of this would be an equipment lease, where at the conclusion of the lease term, the title transfers to the lessee.
The agreement contains a provision where lessees have the option to purchase the asset, and that option is reasonably certain to be exercised. To determine if this provision applies, a company would evaluate an agreement with a purchase option, and may consider factors such as, if the price is lower than the asset’s expected fair value and whether or not the leased asset would be hard for the lessee to replace. For example, if a piece of equipment is highly customized and integral to a company’s business, the company may choose to exercise the purchase option at the end of the lease term.
Lease term and the remaining economic life of the asset
This criteria is triggered if the lease term represents the major part of the asset’s economic life. The bright lines (specific thresholds) for this test was removed under ASC 842. “Major part” is not defined under ASC 842, however, ASC 842-10-55-2 provides guidance that an organization could continue to use the 75% threshold (used in ASC 840) for remaining economic life of the underlying asset to define a major part of the asset. For example, if your organization has a forklift whose useful life is ten years and the organization signs a lease agreement for an 8 year lease term at commencement, this rule would apply. Please note, this particular criterion does not require consideration if the lease’s commencement date occurs near the end or at the end of the underlying asset’s economic life.
Present value vs fair value of the asset
This criteria is triggered if the present value of lease payments over the term, calculated at lease commencement, equals or exceeds substantially all of the fair value of the asset. The bright lines (specific thresholds) test for this criteria under ASC 840 was also removed under ASC 842. While “substantially all” is not defined under ASC 842, ASC 842-10-55-2 provides guidance that a company could continue to use the 90% threshold under in ASC 840 to define substantially all of the fair value of the underlying asset.
It’s important to determine your organization’s internal policy for each threshold for the classification criteria, document it, and follow it consistently. In our experience, almost all of LeaseQuery’s clients have chosen to keep the existing thresholds of 75% and 90% for continuity purposes.
This criterion requires the lessee to consider if the asset is so specialized in nature that it provides no alternative use to the lessor (and therefore would not provide any future value to the lessor) after the lease term.
While the first four criteria were present under ASC 840, the fifth and final criteria is new under ASC 842. Though we mentioned that a lease must meet a minimum of one of these five criteria to be considered a finance lease, we have found that if a lease triggers this fifth test, it has also triggered one of the other four tests. The reason for this is because most landlords would likely factor in the future use for the asset when establishing the lease payments. As such, the fourth test would be triggered too.
Operating vs finance leases under IFRS 16
Under IAS 17, there were two types of leases, finance and operating, with differing accounting policies and disclosures for each. Under IFRS 16, however, there is only one classification, finance leases, which are classified on the financial statements as long-term debt. Leases now follow a single model, and therefore, instead of a question on classification, the decision focuses on whether the agreement meets the definition of a lease agreement and a corresponding asset and lease liability should be recorded.
Operating vs finance leases under GASB 87
Leases under GASB 87 follow a single classification model, in which all leases are finance leases. The rationale for this classification from GASB is conveyed in the Basis of Conclusion for GASB 87 which states the “statement is based on the foundational principle that leases are financings.”
As finance leases, all leases recognized in accordance with GASB 87 have a right-of-use (ROU) asset and a corresponding lease liability recorded. Unlike the other new lease standards, under GASB 87, a contract that transfers ownership of the asset at the end of the contract is not accounted for as a lease, but instead as a financed purchase (i.e. debt).
We hope the information above will help clarify the differences in classification of finance leases and operating leases within each standard. For more information about the new lease accounting standards, visit our resources page.