A company leases a machine under a 5-year lease term, with no option to purchase. The machine's useful life is 7 years. The present value of lease payments is $450,000, and the fair value of the machine is $500,000. The lease payments do not include a bargain purchase option, and the underlying asset is not of a specialized nature. The company does not elect the short-term lease exception. How should this lease be classified by the lessee under ASC 842?
- AFinance lease, due to the lease term criterion.
- BOperating lease, as none of the finance lease criteria are met.
- COperating lease, because fair value is greater than the present value of lease payments.
- DFinance lease, due to the present value of lease payments criterion.
Show answer & explanationAnswer & explanation
Correct answer: D. Finance lease, due to the present value of lease payments criterion.
Under ASC 842, a lease is classified as a finance lease if any one of five criteria is met. One criterion is if the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset. Here, $450,000 (PV of payments) is 90% of $500,000 (fair value), which is considered substantially all. The lease term (5 years) is 71% of the useful life (7 years), which is also considered substantially all. However, the PV criterion is explicitly met. Note: Only one criterion needs to be met.
Why the other options are wrong
- A. The lease term (5 years) is 71% of the useful life (7 years), which also meets a finance lease criterion, but the PV criterion is a more direct hit in this scenario.
- B. At least one finance lease criterion (PV of payments) is met, so it cannot be an operating lease.
- C. The relationship between fair value and PV of payments (90%) indicates a finance lease, not an operating lease.
ASC 842 Lease Classification (Lessee)
ASC 842 classifies leases for lessees as either finance leases or operating leases based on five criteria, determining the accounting treatment for the right-of-use asset and lease liability.
- Finance lease criteria: Transfer of ownership, purchase option 'reasonably certain', lease term 'major part' of useful life, PV of payments 'substantially all' of fair value, specialized asset.
- If any criterion is met, it's a finance lease; otherwise, it's an operating lease (unless short-term).
- Both types result in a ROU asset and lease liability on the balance sheet.
Memory trick: OTIS-S spells finance, if any shine.