Understanding ASC 842 and IFRS 16
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      3. Understanding ASC 842 and IFRS 16

      How to Perform the Lease Classification Test

      A lessee shall classify a lease as a finance lease when the lease meets any of the following criteria at the  lease commencement date:

      1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
            • For this criterion to be met, title must be transferred at little or no cost to the lessee shortly after the end of the lease term.
            • If paying the fee (even when the fee is nominal) is optional, the lease would not explicitly meet this criterion but would still be evaluated under the option to purchase criterion below.
      2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
            • “Reasonably certain” is meant to be a high threshold and is a higher threshold than “probable” under ASC 450. 
            • ASC 842 includes certain factors a lessee should evaluate when determining whether exercise of a purchase option is reasonably certain, including contract-based, asset-based, entity-based, and market-based factors. Generally speaking, after considering these factors, the lessee should evaluate whether it has an economic compulsion or incentive to exercise its purchase option, since this is a strong indicator that exercise of the option is reasonably certain. 
      3. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the lease commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease. Although ASC 842 does not have any bright lines when determining lease classification, one reasonable approach to assessing the criteria in paragraphs would be to conclude:
          • Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
          • A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.
      4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments exceeds substantially all of the fair value of the underlying asset. 
          • Ninety percent of more of the fair value of the underlying asset amounts to substantially all of the fair value of the underlying asset. 
          • Residual Value Guarantees: There is a significant difference between residual guarantees related to determining lease payments for lease measurement purposes and those related to evaluating lease classification. For lease payments, a lessee would only include the amount that it is probable. 
      5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
            • The basis for this determination is that when an underlying asset has no alternative use to the lessor at the end of a lease term, it is presumed that the lessee will consume all (or substantially all) of the benefits of the asset.

      If an entity decides to apply the bright-line thresholds in ASC 840 when classifying a lease, the entity would apply those thresholds consistently to all of its leases.

      For more information, refer to our ASC 842 Survival kit here.

      Accounting Guidance Referenced:

      • ASC 842-10-25-2
      • ASC 842-10-25-2(c) through (d) 
      • ASC 842-10-25-3(b)(1) 
      • Deloitte A Roadmap to Applying the New Leasing Standard (2020) 8.3.3.3- 8.3.3.7