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3.5 Lessee classification examples
Publication date: 31 May 2023
us Leases guide
Lessee classification is based on whether a lease is effectively a financed purchase or an arrangement to obtain usage rights to an asset for a specified period. If one or more of the classification criteria in ASC 842-10-25-2 are met, the lease should be classified as a finance lease by the lessee. If none of the criteria are met, the lease should be classified as an operating lease. The following examples illustrate some of the items that lessees will need to consider when evaluating lease classification:
- Finance leases: Example LG 3-19 and Example LG 3-20
- Operating leases: Example LG 3-21, Example LG 3-22, and Example LG 3-23
EXAMPLE LG 3-19
Lease classification – non-specialized digital imaging equipment lease (lessee)
Lease classification – non-specialized digital imaging equipment lease (lessee)
Lessee Corp enters into a lease of non-specialized digital imaging equipment with Lessor Corp. The following table summarizes information about the lease and the leased assets.
Lease term
| 5 years, no renewal option
|
Economic life of the equipment
| 6 years
|
Purchase option
| None
|
Annual lease payments
| $1,100
|
Payment date
| Annually on January 1
|
Lessee Corp’s incremental borrowing rate
| 7%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
|
Other
|
|
How should Lessee Corp classify the lease?
Analysis
Lessee Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and ASC 842-10-25-3.
Criteria | Analysis |
Transfer of ownership
| Ownership of the asset does not transfer to Lessee Corp by the end of the lease term. |
Purchase option which the lessee is reasonably certain to exercise
| The lease does not contain a purchase option.
|
Lease term is for the major part of the remaining economic life of the asset
| Lessee Corp is utilizing the asset for approximately 83% of the economic life of the asset (5-year lease/6-year economic life), which is deemed to be a major part.
|
Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset
| The present value of the lease payments (discounted at Lessee Corp’s incremental borrowing rate of 7%) is $4,825.
Therefore, the present value of the lease payments amounts to approximately 97% of the fair value of the leased asset ($4,825/$5,000), which is substantially all of the fair value of the leased asset.
|
Specialized nature
| The digital imaging equipment is non-specialized and could be used by another party without major modifications.
|
Lessee Corp should classify the lease as a finance lease because the lease term is for the major part of the economic life of the equipment and the present value of the lease payments amounts to substantially all of the fair value of the underlying asset.
See Example LG 4-2 for an illustration of the initial recognition and measurement of this type of lease.
EXAMPLE LG 3-20
Lease classification – real estate lease with a purchase option (lessee)
Lease classification – real estate lease with a purchase option (lessee)
Lessee Corp enters into a property (land and building) lease with Lessor Corp. The following table summarizes information about the lease and the leased asset.
Lease term
| 10 years
|
Renewal option
| Five 5-year renewal options
If exercised, the annual lease payments are reset to then current market rents.
|
Economic life of the property
| 40 years
|
Fair value of the leased property
| $5,000,000
|
Purchase option
| Lessee Corp has an option to purchase the property at the end of the lease term for $3,000,000.
|
Annual lease payments
| The first annual lease payment is $500,000, with increases of 3% per year thereafter.
|
Payment date
| Annually on January 1
|
Incentive
| Lessor Corp gives Lessee Corp a $200,000 incentive for entering into the lease (payable at the beginning of year 2), which is to be used for normal tenant improvements.
|
Discount rate
| Since both the lease payments required during the lease and the purchase option price are fixed, Lessee Corp can combine these cash flows with its estimate of the property’s fair value to determine that the interest rate Lessee Corp incurs during the lease is 9.04%. However, because Lessee Corp cannot be sure of Lessor Corp’s estimate of fair value or whether Lessor Corp realized any investment tax credits with respect to the property, this rate is not the rate implicit in the lease. Consequently, Lessee Corp compares the rate to other evidence of its borrowing rates in similar circumstances, and concludes that this rate is a reasonable estimate of its incremental borrowing rate.
|
Other
|
|
How should Lessee Corp classify the lease?
Analysis
Lessee Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and ASC 842-10-25-3.
Criteria | Analysis |
Transfer of ownership
| Ownership of the asset does not transfer to Lessee Corp by the end of the lease term.
|
Purchase option which the lessee is reasonably certain to exercise
| The lease contains an option to purchase the property for $3,000,000, which is below the fair value of the real estate asset at lease commencement and its expected value at the date of exercise. Options to purchase real estate at a price below commencement date fair value are generally considered to be reasonably certain of exercise since real estate generally appreciates in value; therefore, a significant economic incentive to exercise the purchase option exists.
|
Lease term is for the major part of the remaining economic life of the asset
| The lease term is 10 years. The five 5-year renewal options available to Lessee Corp are not reasonably certain of exercise (at lease commencement) because the renewal options require rent to be reset to market rates when exercised. Therefore, Lessee Corp is utilizing the asset for 25% of the economic life of the asset (10-year lease/40-year economic life), which is not deemed to be a major part.
|
Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset
| The lease payments net of the incentive Lessor Corp pays Lessee Corp are $5,531,940 (see below for a schedule of payments). The present value of the lease payments (discounted at the rate Lessor Corp charges in the lease of approximately 9.04%) is $3,737,510.
Because the purchase option is reasonably certain of being exercised, it should be included as a lease payment at the end of the lease term. Using the 9.04% rate Lessor Corp charges Lessee Corp, the present value of the purchase option is $1,262,490.
Therefore, the present value of the lease payments represents 100% of the fair value of the leased asset (($3,737,510 + $1,262,490)/$5,000,000).
|
Specialized nature
| Although the property is in a specific location, it could be used by another party without major modifications.
|
The following table shows the schedule of lease payments.
Date | Amount |
Year 1 | 500,000 |
Year 2 (515,000 – 200,000 lease incentive) | 315,000 |
Year 3 | 530,450 |
Year 4 | 546,364 |
Year 5 | 562,754 |
Year 6 | 579,637 |
Year 7 | 597,026 |
Year 8 | 614,937 |
Year 9 | 633,385 |
Year 10 | 652,387 |
Total | $5,531,940 |
Lessee Corp should classify the lease as a finance lease because, at lease commencement, the fixed price purchase option available to Lessee Corp at the end of the initial lease term (i.e., after 10 years) is reasonably certain to be exercised by Lessee Corp. As a result, Lessee Corp has effectively obtained control of the underlying asset. The lease also has payments equal to substantially all of the fair value of the underlying asset.
See Example LG 4-3 for an illustration of the initial recognition and measurement of this type of lease.
EXAMPLE LG 3-21
Lease classification – automobile lease (lessee)
Lease classification – automobile lease (lessee)
Lessee Corp leases an automobile from Lessor Corp. The following table summarizes information about the lease and the leased asset.
Lease term
| 3 years, no renewal option
|
Economic life of the automobile
| 6 years
|
Purchase option
| Lessee Corp has the option to purchase the automobile at fair market value upon expiration of the lease.
|
Monthly lease payments
| $500
|
Payment date
| Beginning of the month
|
Lessee Corp’s incremental borrowing rate
| 6%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
|
Other
|
|
How should Lessee Corp classify the lease?
Analysis
Lessee Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and ASC 842-10-25-3.
Criteria | Analysis |
Transfer of ownership
| Ownership of the asset does not transfer to Lessee Corp by the end of the lease term.
|
Purchase option which the lessee is reasonably certain to exercise
| At lease commencement, it is not reasonably certain that Lessee Corp will exercise the purchase option.
Lessee Corp does not have a significant economic incentive to exercise the purchase option because the option is at fair value at the expiration of the lease.
|
Lease term is for the major part of the remaining economic life of the asset
| Lessee Corp is utilizing the asset for 50% of the economic life of the asset (3-year lease/6-year economic life), which is not deemed to be a major part.
|
Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset
| The present value of the lease payments (discounted at Lessee Corp’s incremental borrowing rate of 6% because the rate charged in the lease is not readily determinable) is $16,518.
Therefore, the present value of the lease payments amounts to approximately 55% of the fair value of the leased asset ($16,518/$30,000), which is not deemed to be substantially all of the fair value of the leased asset.
|
Specialized nature
| The automobile is non-specialized and could be used by another party without major modifications.
|
Lessee Corp should classify the lease as an operating lease because none of the criteria in ASC 842-10-25-2 and ASC 842-10-25-3 have been met.
See Example LG 4-4 for an illustration of the initial recognition and measurement of this type of lease.
EXAMPLE LG 3-22
Lease classification – copier with lease and nonlease components (lessee)
Lease classification – copier with lease and nonlease components (lessee)
Lessee Corp leases a copier from Lessor Corp. The following table summarizes information about the lease and the leased asset.
Lease term
| 3 years, no renewal option
|
Economic life of the copier
| 5 years
|
Purchase option
| None
|
Annual lease payments
| $500, which includes Lessor maintenance for the term of the lease.
Lessor Corp normally leases the same copier for $475 per year and offers a maintenance contract for $75 per year.
|
Payment date
| Annually on January 1
|
Lessee Corp’s incremental borrowing rate
| 5.5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
|
Other
|
|
Lessee Corp has not made an accounting policy election to not separate the lease and nonlease components for this class of asset.
How should Lessee Corp classify the lease?
Analysis
Lessee Corp should first separate the contract into its lease and nonlease components. Per ASC 842-10-15-33, a lessee should allocate the consideration in a contract to the lease and nonlease components based on their relative standalone price, as shown here.
Standalone price (A) | Allocated % (A/$550) = (B) | Annual lease payment (C) | Allocated lease payment (B × C) = D | |
Annual copier lease payment | $475 | 86.36% | $ 500 | $432 |
Annual maintenance contract fee | 75 | 13.64% | 500 | 68 |
Total | $550 | 100.00% | $500 |
Lessee Corp should then assess the lease classification using the criteria outlined in ASC 842-10-25-2 and ASC 842-10-25-3.
Criteria | Analysis |
Transfer of ownership
| Ownership of the asset does not transfer to Lessee Corp by the end of the lease term.
|
Purchase option which the lessee is reasonably certain to exercise
| The lease does not contain a purchase option.
|
Lease term is for the major part of the remaining economic life of the asset
| Lessee Corp is utilizing the asset for 60% of the economic life of the asset (3-year lease/5-year economic life), which is not deemed to be a major part.
|
Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset
| The present value of the lease payments allocated to the lease component (discounted at Lessee Corp’s incremental borrowing rate of 5.5%) is $1,229.
Therefore, the present value of the lease payments amounts to approximately 61% of the fair value of the leased asset ($1,229/$2,000), which is not deemed to be substantially all of the fair value of the leased asset.
|
Specialized nature
| The copier is non-specialized and could be used by another party without major modifications.
|
Lessee Corp should classify the lease as an operating lease because none of the criteria in ASC 842-10-25-2 and ASC 842-10-25-3 have been met.
See Example LG 4-5 for an illustration of the initial recognition and measurement of this type of lease.
EXAMPLE LG 3-23
Lease classification – lease payments tied to an index (lessee)
Lease classification – lease payments tied to an index (lessee)
Lessee Corp enters into a lease of equipment with Lessor Corp. The following table summarizes information about the lease and the leased assets.
Lease term
| 4 years, no renewal option
|
Economic life of the equipment
| 7 years
|
Purchase option
| None
|
Annual lease payments
| The first annual payment is $1,500.
The annual payment increases each subsequent year by an amount equal to the prior year rent multiplied by the Prime Rate. For example, if the Prime Rate is 3%, then the lease payment would be $1,545 ($1,500 + ($1,500 × 3%)).
|
Payment date
| Annually on January 1
|
Lessee Corp’s incremental borrowing rate
| 8%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
|
Other
|
|
Prime rate at the lease commencement date is 3%. The Prime Rate is expected to increase .25% each year (i.e., the Prime Rate is expected to be 3.25% at the beginning of year 2).
How should Lessee Corp classify the lease?
Analysis
Lessee Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and ASC 842-10-25-3.
Criteria | Analysis |
Transfer of ownership
| Ownership of the asset does not transfer to Lessee Corp by the end of the lease term.
|
Purchase option which the lessee is reasonably certain to exercise
| The lease does not contain a purchase option.
|
Lease term is for the major part of the remaining economic life of the asset
| Lessee Corp is utilizing the asset for 57% of the economic life of the asset (4-year lease/7-year economic life), which is not deemed to be a major part.
|
Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset
| The variable lease payment should be included in fixed lease payments using the Prime rate at lease commencement. The total payments are $6,275.
The present value of the lease payments (discounted at Lessee Corp’s incremental borrowing rate of 8%) is $5,595.
Therefore, the present value of the lease payments amounts to approximately 56% of the fair value of the leased asset ($5,595/$10,000), which is not deemed to be substantially all of the fair value of the leased asset.
|
Specialized nature
| The equipment is non-specialized and could be used by another party without major modifications.
|
The following table shows the schedule of lease payments.
Date | Amount |
Year 1 | $1,500 |
Year 2 | 1,545 |
Year 3 | 1,591 |
Year 4 | 1,639 |
Total | $6,275 |
Lessee Corp should classify the lease as an operating lease because none of the criteria in ASC 842-10-25-2 and ASC 842-10-25-3 have been met.
See Example LG 4-6 for an illustration of the initial recognition and measurement of this type of lease.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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