Definition
A lessee classifies a lease as a finance lease if it meets any one of five criteria: ownership transfers by the end of the term; the lessee has a purchase option it is reasonably certain to exercise; the term covers a major part of the asset's remaining economic life; the present value of payments (plus any residual guarantee) is substantially all of the asset's fair value; or the asset is so specialized that it has no alternative use to the lessor. ASC 842 gives 75% of the remaining economic life and 90% of fair value as examples of reasonable thresholds, not bright lines. Otherwise, it is an operating lease.
Why it matters in an audit or review
Classification changes the income statement (interest and amortization versus a single lease cost), the cash flow statement (principal in financing for finance leases), and ratios such as EBITDA. Auditors test each criterion on significant leases, and the reassessment triggers.
Example
(Illustrative) A $100,000 vehicle lease for four years of a five-year useful life, with PV of payments at $95,000, meets the term and PV criteria and is a finance lease. Expense is interest plus straight-line amortization.
Common mistakes
- Applying the 75% and 90% thresholds as bright lines without judgment.
- Not classifying at commencement.
Sources
- FASB ASC 842-10-25-2, Leases, lease classification criteria for lessees
- FASB ASC 842-10-55-2, Leases, implementation guidance on the economic life and fair value criteria
- FASB ASC 842-20-45, Leases, lessee presentation
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error