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How do companies determine whether to use the finance method or the operating method? From the lessee’s perspective, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset. If the lease transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as a finance lease. In this situation, the lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term. All leases that do not meet any of the finance lease tests are classified as operating leases. In an operating lease, a lessee obtains the right to use the underlying asset but not ownership of the asset itself.
For example, a lease may convey use of one floor of an office building for five years. At the end of the lease, the lessee vacates the floor and the lessor can then lease the floor to another tenant. So this lease (an operating lease) conveys right-of-use but not ownership; the lessee controls the leased asset only during the five-year lease. As we will see, the accounting for a lease classified as a finance lease (transfer of control or ownership) or an operating lease (transfer of right-of-use) reflects differences in control conveyed in a lease arrangement.
Transfer of Ownership Test
If the lease transfers ownership of the asset to the lessee, it is a finance lease. This test is not controversial and easily implemented in practice.
Purchase Option Test
A purchase option test is met if it is reasonably certain that the lessee will exercise the option. In other words, the lease purchase option allows the lessee to purchase the property for a price that is significantly lower than the underlying asset’s expected fair value at the date the option becomes exercisable (hereafter referred to as a bargain purchase option).
Lease Term Test
When the lease term is a major part of the remaining economic life of the leased asset, companies should use the finance method in accounting for the lease transaction. The question is, what is a major part of the economic life of a leased asset? Although the FASB indicates that companies should use judgment in evaluating the lease term test, it recognizes that additional implementation guidance would be helpful. As a result, the Board establishes an implementation guideline that companies might use. That is, if the lease term is 75 percent or greater of the economic life of the leased asset, the lease meets the lease term test and finance lease treatment is appropriate (often referred to as the 75% test).2 This guideline should be used for homework purposes.
Another factor to consider in the lease term test is a bargain renewal option. For example, a lease term is generally considered to be the fixed, non-cancelable term of the lease. However, a bargain renewal option allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the time the option becomes exercisable. At the commencement of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably certain.3 Thus, companies should include in the lease term any bargain renewal periods.
Present Value Test
If the present value of the lease payments is reasonably close to the fair value of the asset, a company is effectively purchasing the asset and should therefore use the finance method to account for the lease. Again, the FASB recognizes that determining what is reasonably close often involves significant judgment and therefore provides an implementation guideline (hereafter referred to as the 90% test). This guideline states that if the present value of the lease payments equals or exceeds 90 percent of the fair value of the asset, then a lessee should use the finance method to record the lease. This guideline should be used for homework purposes. To apply the present value test, a lessee must determine the amount of lease payments and the appropriate discount rate.
Lease Payments. The lease payments generally include the following:
1.Fixed payments. These are the rental payments that are specified in the lease agreement and fixed over the lease term.
2.Variable payments that are based on an index or a rate. The lessee should include variable lease payments in the value of the lease liability at the level of the index/rate at the commencement date. When valuing the lease liability, no increases or decreases to future lease payments should be assumed based on increases or decreases in the index or rate