A company leases a machine under a 5-year lease term, with no option to purchase. The machine has an economic life of 7 years. The present value of lease payments is $450,000, which is 80% of the machine's fair value. The lease does not transfer ownership, nor does it contain a purchase option the lessee is reasonably certain to exercise. The machine is not of a specialized nature. How should the lessee classify this lease under ASC 842?
- ADirect Financing Lease
- BFinance Lease
- COperating Lease
- DSales-Type Lease
Show answer & explanationAnswer & explanation
Correct answer: C. Operating Lease
Under ASC 842, a lease is classified as a finance lease if it meets any one of five criteria (OWNS test). If none of the OWNS criteria are met, it is classified as an operating lease. O - Ownership transfer: No. W - Written purchase option reasonably certain to exercise: No. N - Net present value of lease payments constitutes substantially all (typically 90% or more) of the fair value of the asset: 80% is not substantially all. S - Specialized asset: No. T - Lease term is for the major part (typically 75% or more) of the economic life of the asset: 5 years / 7 years = 71.4%, which is not a major part (less than 75%). Since none of the criteria are met, the lease is an operating lease.
Why the other options are wrong
- A. Sales-type and direct financing leases are lessor classifications, not lessee.
- B. A finance lease would require at least one of the OWNS/75%/90% criteria to be met.
- D. Sales-type and direct financing leases are lessor classifications, not lessee.
ASC 842 Lessee Lease Classification
Under ASC 842, a lessee classifies a lease as a finance lease if any of the 'OWNS' criteria are met; otherwise, it's an operating lease.
- O: Ownership transfers.
- W: Written purchase option reasonably certain to exercise.
- N: Net PV of payments is substantially all of fair value (>=90%).
- S: Specialized asset with no alternative use.
- T: Lease term is major part of economic life (>=75%).
Memory trick: OWNS a Tiny asset, then it's finance; otherwise, just operate and dance.