Lease term and the five classification criteria

• Determine the lease term including options reasonably certain to be exercised
• Apply the five finance lease criteria in 842-10-25-2
• Use the 75 percent and 90 percent reasonable approach in 842-10-55-2 with judgment
• Document the classification conclusion for audit

The lease term drives everything

Classification, the liability and the ROU asset all depend on the lease term. Under 842-10-30-1 the lease term is the noncancellable period plus:

• periods covered by an option to extend if the lessee is reasonably certain to exercise it,
• periods covered by an option to terminate if the lessee is reasonably certain not to exercise it, and
• periods covered by an option to extend (or not terminate) whose exercise is controlled by the lessor.

At commencement the entity considers all factors that create an economic incentive for the lessee: contract-based, asset-based, entity-based and market-based (842-10-30-2). Significant leasehold improvements that would be abandoned, a below-market renewal rate, a costly relocation, or a facility that is central to operations all push toward including the renewal period. Management intent alone is not enough; "reasonably certain" is a high threshold.

After commencement the lessee reassesses the term only on the triggers in 842-10-35-1, such as a significant event within the lessee's control that directly affects whether it will exercise an option.

The five criteria

A lessee classifies a lease as a finance lease if it meets any one of these at commencement (842-10-25-2):

1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2. The lease grants an option to purchase the asset that the lessee is reasonably certain to exercise.
3. The lease term is for the major part of the remaining economic life of the asset. This criterion is not used when commencement falls at or near the end of the asset's economic life.
4. The present value of the lease payments plus any lessee residual value guarantee not already in the payments equals or exceeds substantially all of the fair value of the asset.
5. The asset is so specialized that it is expected to have no alternative use to the lessor at the end of the term.

If none is met, the lessee classifies the lease as operating (842-10-25-3).

The reasonable approach in 842-10-55-2

The Codification does not set bright lines, but 842-10-55-2 describes one reasonable approach: 75 percent or more of remaining economic life is a major part; a commencement in the last 25 percent of total economic life is at or near the end; and 90 percent or more of fair value is substantially all. Many entities adopt these as policy. If a client uses them, the policy should say so and be applied consistently; a lease at 74 percent is not automatically operating if other facts point the other way.

Practical points

• Land and buildings. Land has an indefinite economic life, so the economic life test rarely applies to a land component. Classify land separately when it is significant.
• Fair value unavailable. If a reasonable estimate of fair value cannot be made without undue cost or effort, 842-10-55-3 requires classification without criterion 4, so criteria 1, 2, 3 and 5 decide.
• Discount rate in criterion 4. A lessee uses its discount rate for the lease. A lower rate produces a higher present value and can flip classification.

Documentation

Keep a classification worksheet per lease: term analysis with each option and the factors considered, the economic life source, fair value source, discount rate, the present value calculation, and the conclusion on each criterion. The classification worksheet template has that layout.

Classifying a packaging line lease at Mesa Verde Bottling Co.