A finance lease is a lease that the lessee classifies as one because the arrangement meets at least one of five criteria at lease commencement: ownership of the underlying asset transfers to the lessee by the end of the term, the lessee holds a purchase option it is reasonably certain to exercise, the term runs for the major part of the asset’s remaining economic life, the present value of the lease payments plus any lessee-guaranteed residual equals or exceeds substantially all of the asset’s fair value, or the asset is so specialized that it is expected to have no alternative use to the lessor at the end of the term. Meet none of them and the lessee has an operating lease instead (FASB Accounting Standards Update 2016-02, paragraphs 842-10-25-2 and 842-10-25-3).
Those five criteria are the same sentence read from two sides, which is where most of the confusion around the term starts. How the classification is argued in a workpaper now that the old bright lines are gone is worked through in ASC 842 lease accounting, and what the lessee then recognizes and how the two expense patterns differ is in right-of-use asset.
The Same Test Gives the Lessor a Different Word
The standard writes both classifications into one sentence. A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of those criteria at lease commencement (FASB Accounting Standards Update 2016-02, paragraph 842-10-25-2).
So under US GAAP finance lease is the lessee’s term and nothing else. A lessor never has a finance lease. It has a sales-type lease, a direct financing lease, or an operating lease, and a firm that writes finance lease into a lessor’s workpaper has used a word the standard does not give that side of the transaction.
The lessor also gets a second chance the lessee does not get. Where none of the five criteria are met, the lessee has an operating lease, full stop. The lessor classifies the lease as an operating lease unless both of two further criteria are met, in which case it is a direct financing lease: the present value of the lease payments plus any residual value guaranteed by the lessee and by any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset, and it is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee (FASB Accounting Standards Update 2016-02, paragraph 842-10-25-3).
Read those two present-value tests side by side, because they are not the same test. The criterion that makes a lease a finance lease counts a residual value guaranteed by the lessee. The criterion that makes it a direct financing lease counts a guarantee from an unrelated third party as well. A residual guaranteed by a third party unrelated to the lessor therefore does nothing to the lessee’s classification and can decide the lessor’s. The lessor assesses both present value tests using the rate implicit in the lease (FASB Accounting Standards Update 2016-02, paragraph 842-10-25-4).
Where the Lessor’s Two Labels Part Company
The difference between them is not presentation, it is when profit is allowed to appear.
On a sales-type lease the lessor derecognizes the underlying asset and recognizes a net investment in the lease, along with any selling profit or selling loss arising from the lease. Initial direct costs go to expense if the fair value of the underlying asset differs from its carrying amount at commencement, and are otherwise deferred into the net investment (FASB Accounting Standards Update 2016-02, paragraph 842-30-25-1).
On a direct financing lease the profit does not appear at commencement at all, and the treatment is deliberately asymmetric. The lessor recognizes a net investment in the lease and a selling loss arising from the lease, if applicable, and derecognizes the underlying asset (FASB Accounting Standards Update 2016-02, paragraph 842-30-25-7), while selling profit and initial direct costs are deferred at the commencement date and included in the measurement of the net investment in the lease (FASB Accounting Standards Update 2016-02, paragraph 842-30-25-8). A day-one loss lands immediately; a day-one gain instead runs out through interest income over the term.
A collectibility gate sits in front of the sales-type route. Where collectibility of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, is not probable at the commencement date, the lessor does not derecognize the underlying asset and instead recognizes lease payments received, including variable lease payments, as a deposit liability (FASB Accounting Standards Update 2016-02, paragraph 842-30-25-3). The asset stays on the lessor’s books and the cash sits in a liability until collection becomes probable or the contract ends. The direct financing route never needs that rule, because probable collection is one of the two criteria a lease has to meet before it can be classified that way at all (FASB Accounting Standards Update 2016-02, paragraph 842-10-25-3).
Classifying a Sublease
A sublease raises a question the criteria do not answer on their face, because the intermediate lessor is leasing out a right rather than a machine. The standard settles it: when classifying a sublease, an entity classifies it with reference to the underlying asset, for example the item of property, plant or equipment that is the subject of the lease, rather than with reference to the right-of-use asset (FASB Accounting Standards Update 2016-02, paragraph 842-10-25-6).
That points the economic-life and fair-value criteria at the building or the equipment itself, not at the remaining term of the head lease, which is usually the answer a preparer expects least.
Under IFRS the Word Sits on the Other Side
IFRS Accounting Standards use the same two words for the opposite party. A lessor classifies each of its leases as either an operating lease or a finance lease, and a lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset (IFRS Foundation, IFRS 16, paragraphs 61 and 62).
The test behind it is a principle rather than a list. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract, and the standard offers examples that would normally lead to finance lease classification, among them transfer of ownership by the end of the term, a purchase option at a price expected to be sufficiently below fair value, a term covering the major part of the economic life, a present value amounting to at least substantially all of fair value, and an asset so specialised that only the lessee can use it without major modifications (IFRS Foundation, IFRS 16, paragraph 63).
Those examples are close cousins of the US criteria, and the standard is explicit that they do not decide the matter. The examples and indicators are not always conclusive, and where it is clear from other features that the lease does not transfer substantially all the risks and rewards incidental to ownership, the lease is classified as an operating lease (IFRS Foundation, IFRS 16, paragraph 65).
For a client reporting under both frameworks, the practical trap is the word rather than the arithmetic. A US lessee’s finance lease and an IFRS lessor’s finance lease are two different parties describing two different sides of a transaction, and neither label transfers to the other framework.
Common Questions
Close enough to explain the confusion and not the same word. Capital lease was the lessee classification under the previous leases guidance, and the current standard renamed it while keeping the test recognizable. Topic 842 retains a distinction between finance leases and operating leases, and its classification criteria for distinguishing between them are substantially similar to the criteria that distinguished capital leases from operating leases in the previous guidance (FASB Accounting Standards Update 2016-02, Background Information and Basis for Conclusions).
What did change is what turns on the answer. Under the previous model the critical determination was whether a lease was a capital lease or an operating lease, because lease assets and lease liabilities were recognized only for capital leases. Under the current standard the critical determination is whether a contract is or contains a lease at all, because lessees recognize lease assets and lease liabilities for finance and operating leases alike, other than short-term leases where the entity elects the exemption (FASB Accounting Standards Update 2016-02, Background Information and Basis for Conclusions).
Rarely, and the trigger is a change in the contract rather than a change in the numbers. An entity does not reassess lease classification after the commencement date unless the contract is modified and the modification is not accounted for as a separate contract, and a lessee also reassesses on a change in the lease term or in whether it is reasonably certain to exercise a purchase option (FASB Accounting Standards Update 2016-02, paragraph 842-10-25-1). A fall in the asset’s fair value, or a rise in market rents, is not a trigger.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own lease classification and schedule work through a trial task before a client engagement depends on it.
