A Comprehensive Guide to Finance Lease Criteria Under ASC 842

The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 842, Leases, significantly changed how lease accounting is handled. Understanding the criteria for classifying a lease as a finance lease under ASC 842 is crucial for accurate financial reporting. This guide provides a comprehensive overview, helping you navigate the complexities of this standard.

Key Criteria for Classifying a Finance Lease under ASC 842

ASC 842 defines a finance lease as a lease that transfers substantially all the risks and rewards incidental to ownership of the underlying asset to the lessee. This determination is based on several key criteria. Let's examine them:

1. Ownership Transfer:

• At the end of the lease term: Does the lease agreement transfer ownership of the asset to the lessee? If so, it's highly likely a finance lease.

2. Bargain Purchase Option:

• Substantially certain: Does the lease include a bargain purchase option (BPO)? A BPO allows the lessee to purchase the asset at a significantly discounted price compared to its fair market value at the time of the option's exercise. If the lessee is substantially certain to exercise the BPO, it suggests a finance lease. The probability of exercising the option is assessed at the lease commencement date.

3. Lease Term:

• Major portion of the asset's economic life: Does the lease term cover a significant portion of the asset's useful life (generally, 75% or more)? If yes, this strongly indicates a finance lease. This criterion looks at the percentage of the asset's total useful life compared to the lease term.

4. Present Value of Lease Payments:

• Essentially all of the asset's fair value: Does the present value of the lease payments (including any guaranteed residual value) essentially equal or exceed substantially all of the underlying asset's fair value at the commencement of the lease? This is a crucial criterion. A lessee needs to calculate the present value using the lessee's incremental borrowing rate.

5. Specialized Asset:

• Specific use: Is the asset so specialized that it's unlikely to have alternative uses to the lessor at the end of the lease term? If so, it may be a finance lease.

Important Considerations:

• Substance over form: ASC 842 emphasizes substance over form. While a contract might not explicitly state a finance lease, the underlying economic realities of the transaction should be considered.
• Professional judgment: Applying these criteria requires careful analysis and professional judgment. Complex lease agreements might require expert consultation to ensure accurate classification.
• Documentation: Thorough documentation is vital. Keep records of the assessment process to support your classification.

Consequences of Incorrect Classification:

Misclassifying a lease can have significant financial reporting implications, affecting the balance sheet, income statement, and cash flow statement. This can lead to inaccurate financial reporting and potential regulatory issues.

Conclusion:

Understanding the finance lease criteria under ASC 842 is essential for accurate financial reporting. While the criteria provide a framework, applying them requires careful consideration of the specific lease agreement and the underlying economic realities. This requires a thorough understanding of the lease terms, present value calculations, and professional judgment. When in doubt, consulting with accounting professionals is recommended. Remember to document your rationale and decisions meticulously.