How do you determine the classification of a lease?
The accounting standards have brought many new rules, including how to treat different kinds of leases. Join Janet Sifers, Senior Director of Product Marketing, LeaseAccelerator and her colleague, Len Neuhaus, CPA, VP of Lease Accounting, LeaseAccelerator, for a brief introduction to the difference between operating leases and finance leases.
To learn more about the different types of leases and how to manage them, visit our website: www.leaseaccelerator.com/solutions/lease-management/
Text version available: How do you determine the classification of a lease
Janet Sifers: Hi everyone I’m Janet Sifers, Head of Product Marketing at LeaseAccelerator. With me today I have Len Neuhaus, a Technical Accounting Expert and CPA.
We’re here to remove some of the complexity around lease accounting. Today we’re going to talk about different types of leases under ASC 842: operating and finance leases. So Len, how do you determine the classification of a lease?
Len Neuhaus: Hi, Janet. Thank you. So under the ASC 842 standard. There are five tests that must be reviewed and if one of the tests is triggered, you have a finance lease. And if none of those five tests are triggered, you have an operating lease.
So let’s talk a little bit about what the five. So the first test is what we call the 75% test. Now the 75% was in bright red line under the old standard ASC a 40 but under the new standard that percentage
Len Neuhaus: And what the standard basically says, is take a look at the useful life of the asset.
And if the term is greater than 75% of the useful life of the asset, then you have a finance lease.
The second test is what we call the 90% that’s, again, the 90% bright red line, and he had see it 40 but now as ASC 842 gives you some flexibility. And that test basically says that you look at the payments and really try to determine if this is a pure financing of an asset. So if 90%
Of the payments are made, then basically, it’s a financing in that situation, you would have a finance asset. The third test is the transfer of ownership. At the end of the lease. So very simple yes or no.
The fourth is the bargain purchase option. So if there is a likelihood that at the end of the lease the asset will be purchased by the lessee from the lessor, you have a finances and most people use a 30% number as the rule of thumb. But again, that is a company policy decision. And then the last test is the new test which talks about the asset itself is the asset made specifically for the lessee.
And if it is, how cumbersome and difficult would it be for the less work to take it and remove it, remarket it to some other individual. Generally if it’s made to suit and it would cost a lot for the lessor to do that, you typically would have a finance lease in that situation, because the asset was made for that specific situation.
Janet Sifers: Great. That makes perfect sense. So at the beginning of a lease, then what are the differences between an operating lease and finance lease?
Len Neuhaus: So when you think about the inception of a lease, the take that entry, the entry that one would record to record the lease liability and the right of use asset. For a finance lease and for an operating least would be exactly the same.
For the liability point of view, you would look at the future cash flows and you would discount those future cash flows based upon the appropriate interest rate or incremental borrowing rate and that becomes your initial lease liability and that initial lease liability becomes the starting point of computing the right of use asset. When you go to future dated accounting, then things will change.
Janet Sifers: Got it. So we talked about the beginning of at least what happens with the accounting from during the term of the lease with an operating lease.
Len Neuhaus: So for an operating lease point of view, the expense is a straight line expense. So if you have a lease. Let’s say that it’s 60 months you’re expensing at the same each of the 60 months and that would be the case whether you have 60 months of equal payments, where you have different payments during that 60-month period.
The way the standard suggests that you compute though, is you first have to look at the interest. And since you have periodic payments, reducing your liability your interest expense component of the straight line expense would be on a downward slope every period.
You also have the amortization component of the right of use asset. So the amortization component would go up every period. While the interest component goes down every period, but combined, you would have a straight line expense. So first, you would do the interest expense component then knowing what your straight line component is used to track the interest expense components and that would be your amortization. At the end of the lease the asset is fully amortized.
Janet Sifers: So now after we’ve talked about the operating lease, so let’s look at the finance lease. So how is it that accounted for? During the term.
Len Neuhaus: So the finance lease starts the same way in that look at the effect of interest method to compute the interest component. And with periodic payments on the liability, the interest expense goes down period over period. But the amortization of the asset is on a straight line basis. So your asset is equal every month. So when you combine an equal amortization with a declining interest expense, the total expense goes down every period through the term of the lease.
Janet Sifers: Great, thank you. That makes a lot of sense. Thank you for that detail on the difference between an operating and finance lease. Thanks everyone for listening and join us next time for more lease accounting essentials.
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