Lease Classifications

Classification test to determine the appropriate accounting treatment

After the firm identifies a lease in the contract, it has to do a classification test to determine the appropriate accounting treatment.

The Financial Accounting Standards Board focuses on improving the financial reporting of lease transactions. Thus on February 25, 2016, they issued an Accounting Standards Update (ASU) topic 842. 

The new guidance points out some standards. Those standards disclose the assets and liabilities resulting from leasing without basis. Such standards need a specification of the lease classification. Lease classification aligns with most of the new guidance of ASU. Such as;

"Results in a more faithful representation of a lessee's rights and obligations arising from a lease" and "Improves understanding and comparability of lessee's financial statements clarify the definition of a lease to address practice issues."

Firms give a classification of the lease increases the clarity between firms.

FASB has been supporting stakeholders with implementation concerns, like:

Comparative reporting requirements for the first adoption. For lessors, only distinguish lease and non-lease components in a contract as businesses get ready to adopt the new lease standard released on February 25, 2016.

In July 2018, FASB amended the ASU (Topic 842) in response to stakeholders' concerns. Thus, classification became an essential part of meeting such requirements.

What are the two major lease classifications?

There are two major types of leases used to classify all the lease obligations and rights;

1) Finance Lease

Finance leases are a subset of leases. That subset ends up with ownership of the lease because the lease lasts for its entire valuable life. The lessee records lease assets and liabilities on the balance sheet in this array.

Under the old standard (2018 and before), capital lease terminology was used instead of finance lease. Within the new standard (2019 and after), Finance lease terminology was used by both International Accounting Standard Board (IASB) and Financial Accounting Standard Board (FASB).

IASB and the FASB worked together on the leasing program. Thus, lessee accounting and lease terminology are identical. 

 2) Operating Lease

Operating leases are the other subset of leases. Unlike the finance lease, the operating lease does not transfer the ownership of the lease to the lessee. The operating lease does not last for the whole useful life of the lease. 

The old standard did not record the operating lease on the balance sheet. In 2005, the Securities and Exchange Commission (SEC) published a study focusing on off-balance sheet items.

The study addressed off-balance-sheet transactions of 1.25 Trillion operating lease commitments for SEC registrants. Accordingly, the SEC recommends changing the existing lease accounting regulations to enable better financial reporting transparency.

After IASB and FASB released the new standard, operating leases became on-balance sheet items. Thus, firms have to record the items on their balance sheet.

The terminology of the operating balance sheet remains the same under the new and old standards.

How do we classify leases from the perspective of the lessee?

 

There are two main types of leases. Once a firm recognizes a lease in the contract, it could either be a finance or an operating lease.

The lease could be classified as an operating lease on the lessee's financial statement if the lease;

  1. Ownership is not transferred. The lessee does not have the option to buy the leased asset. Thus, the lease remains on the lessor balance sheet. There is no ownership transfer at the end of the lease term. Once the lease terms end, there is no right for the lessee on the lease.
  2. There isn't a buy option. The contract of the lease does not include a buy option. Thus, there is no possibility of buying the lease. Therefore, there is no other choice for the lessee to own the underlying asset.                                                                                                                                                                                                                                               
  3. The lease term is less than the useful life of the lease. The lease term is part of the underlying asset's economic life. (For example; a car that has a useful life of ten years has a lease term of six years)                                                                                                                                                                                            
  4. The present value of all the lease payments is less than the current cost of the underlying asset. For instance, a car that costs $30,000 has an annual lease payment of $3,000 for ten years.  Also, assume 8% is the appropriate discount rate. When solving for the present value of a ten years annuity, we will get $20,130.24, which is lower than the current cost, approximately 67% of the current cost.                                                                                                                              
  5. And the lessor can put the lease to other uses. The lessor expects the lease to have another use of the underlying asset after the end of the lease term. For example, the lessor could lease the underlying or sell it. The lease could be classified as an operating lease only if all the conditions above fit the tested lease. 

How do we classify leases as finance leases?

The same characteristics that define the operating lease are used to define the finance lease. Then, it is ready to be on the lessee's financial reports as an operating lease if the lease:

  1. Ownership of the lease can be transferred to the lessee account. For example, a finance lease can transfer ownership. In this case, it is possible when the lease contract allows for the transfer of ownership. Sometimes after a certain number of the lease payment. Those payments rely on the smallest necessary required by law to transfer title.                                                                                                                  
  2. The choice to buy the lease The lessee has the choice to get the underlying asset after a certain time of the lease term. (example; a machine has an annual lease payment of $500 and a buy option after the fourth year with the price of $1000)                                                                                                                                                                                                                                      
  3. The lease's term is almost the useful life of the lease. The lease's term usually ranges between 75% to 100% of the underlying asset's economic life. For instance, a machine with a life expectancy of 10 years. The machine has a lease term of 8 years, which represents 80% of the economic life of the machine (10 years)                                                                                                                                                                                           
  4. The PV of the lease payment is equal to or more than the current cost of the underlying asset. Consider the previous example of the car. Instead of an annual payment of $3,000, we will assume a $5,000 annual lease payment. Solving for the PV, we get $33,550.41, which is higher than the current cost of the car ($30,000)                                                                                                                      
  5. Or there is no other alternative use of the lease for the lessor. It is supposed that the lessor will have no other use for the underlying lease at the end of the lease period.

A lease classifies as a finance lease if one of the previous conditions matches the tested lease. 

The table below summarizes the classification key characteristics of the lease.

Key Characteristics
Lease ClassificationOwnershipThe choice to buy the leaseLease TermsPayments PVAlternative use
FinancingYesYes75% - 100%≥ current costNo
OperatingNoNo<75%<Current costYes

How do we classify leases from the perspective of the lessor?

From ASC 840 to ASC 842, the accounting for the lessor is similar. The standards for balance sheet recognition remain unchanged. Lessors continue to report lease revenue for their leases. 

To enable the adoption of the new standard, lessors can choose a set of expedients. Under this, the lessor is not forced to reevaluate lease categorization. Thus, many lessors will choose to stick with the existing lease classifications.

ASC 842 is more of a performance enhancement than a redesign of how the lessor handles the lease. The terms in financial statements are rent revenue becomes lease revenue. And also, rent receivable becomes a net investment in the lease.

After confirming that a lease exists, the next step for lessors is identifying the type of lease. Leases are often categorized as either operating leases or financing leases. 

The lessee and the lessor classify the lease as an operating and/or finance lease. Finance leases are further classified. A finance lease is a sales-type or direct financing lease for the lessor.

Sales-type lease 

Lessors must classify a sales-type lease under ASC 842, where lessors should make up a lease receivable and interest revenue.

Thus if any of the following conditions are true, then the lease is a sales-type lease:

  1. By the end of the lease period, the lessee acquires ownership of the underlying asset.
  2. The lease gives the lessee an option to buy the underlying asset, which the lessee is likely to exercise.
  3. The lease term covers most of the underlying asset's remaining economic life.
  4. The leased asset is so specialized that the lessor anticipates having no other use for it. So, at the end of the lease period, the lessor sells off the lease. 
  5. The present value of the total lease payments is more than or equal to almost all the asset's fair value. Plus, any residual value guarantees are made by the lessee.

After that, reclassify the lease's net investment into the most suitable fixed asset category. The residual asset and lease receivables have their carrying amounts. They added together to create the reclassified asset. 

Lessors have to determine if the lease's net investment is impaired. The lessor must record an impairment loss if the lease contract ends before maturity.

Direct financing

A lease must be classified as direct financing by the lessor. To do so, the tested lease didn't meet the sales-type condition.

Furthermore, the leases have to meet the following two conditions:

  1. First, the lessor will likely get the lease payments. Also, the lessor will require extra sums to fulfill a residual value guarantee.
  2. Present value of the sum of lease payments and any residual value guaranteed by the lessee (not already reflected in lease payments) and/or any other third-party payments unrelated to the lessor are greater than or equal to substantially all of the fair value (which is generally cost basis) of the underlying asset.

The establishment of a lease receivable and interest revenue by lessors is also needed under direct financing. Revenue is the crucial distinction between sales-type leases and direct financing.

The underlying asset is under the lessee's control with a sales type. Lessor records sales revenue and profit at the start of the lease. 

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Researched and authored by Ahmed Nammer | Linkedin

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