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Classification of a lease

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Required fields for classification

To determine the classification of a lease (whether it is capital or operating), several items of information are needed. The following sections describe how to determine what to enter into EZLease on the lease record:


Lease term
Minimum lease payments
Appropriate interest rates
Fair value

ASC 842 Classification

The definition of a finance lease replaces the specific quantitative tests for a FAS 13 capital lease with “principles-based” tests largely taken from IAS 17:

  • (a) The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
  • (b) The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
  • (c) The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
  • (d) The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
  • (e) The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.” [842-10-20]

However, the FASB endorses using essentially the same quantitative criteria as under FAS 13 in 842-10-55-2, calling them “a reasonable approach.” This permits using other criteria if a user wishes to, but it would be expected that any other methodology would need to be similar and used consistently. EZLease uses the FAS 13 criteria, but permits the user to override the classification determined. One significant difference from FAS 13 is that the present value test is still used if the lease is in the last 25% of the underlying asset’s economic life. Also, ASC 842 calls for separating the land and building portions of a lease as separate components [842-10-15-29], with the rent allocated according to the fair value. ASC 842 adds a third classification type: Short Term, applicable to leases with a lease term of 12 months or less. This includes options whose exercise is “reasonably certain,” the criterion used to determine whether options generally should be considered part of the lease term of a lease.

 

Land and building leases, when the land is for more than a minor part of the lease, have to be split into two separate records; a combined land (operating) and building (finance) portion cannot easily be combined, because operating and finance balance sheet values need to be reported separately.


IFRS 16/GASB 87 Classification

IFRS 16 and GASB 87 eliminate the distinction between finance and operating leases. “Operating” no longer exists as a type of lease. However, both include the Short Term classification type for leases of 12 months or less, the same as ASC 842; IFRS 16 adds another type, Low Value, for leases of low-value assets. The IASB in its Basis for Conclusions states that this is intended to cover assets whose value when new is less than approximately US$5,000. (Note that a lease of a used asset which, when new, was of a higher value, such as a vehicle, would not be covered by this.) Low-value leases are treated like IAS 17 operating leases or short-term leases, including rent leveling if there are scheduled rent increases. You may specify the exact threshold amount in whatever currency you are using in System Options; you may also choose to check the Low Value box on a lease that doesn't automatically qualify (for instance, because you don't enter a fair value amount).

 

FAS 13 Classification

According to FAS 13, there are four tests to determine whether a lease should be considered capital. If any one of the tests is met, the lease is a capital lease. Since these are in paragraph 7 of FAS 13, they are often known as the 7(a)-7(d) tests:

 

Tests (c) and (d) do not apply “if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use.” [¶7]

In certain circumstances, a single lease agreement may give rise to both a capital and an operating lease. This can happen if the lease covers both a building and land (typically under and around it), and the fair value of the land is 25% or more of the total fair value of the leased property. In such a situation, the two pieces should be separated. If test 7(a) or 7(b) is met, both pieces will be capital; however, land is not depreciated. If neither of these tests is met, the land element of the lease is always an operating lease; the building element is tested separately (using just the rents and fair value applicable to the building), and if it meets test 7(c) or 7(d), it is accounted for as a capital lease. If the value of the land is less than 25% of the entire property, the two elements are combined and tested and accounted for together. [¶26] (In the rare case of a lease that combines land and equipment, the two elements are always accounted for separately, no matter how small the land element. [¶27])

 

 

 

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