CPA Exam - FAR (Financial Accounting and Reporting)Select TransactionsMedium
A company enters into a 5-year lease for equipment. The present value of the lease payments is $450,000. The fair value of the equipment is $500,000. There is no bargain purchase option, and the lease does not transfer ownership at the end of the lease term. The lease term is 75% of the economic life of the asset. The present value of lease payments is 90% of the fair value of the asset. How should this lease be classified by the lessee under ASC 842?
- ASales-Type Lease
- BOperating Lease
- CFinance Lease
- DDirect Financing Lease
Show answer & explanationAnswer & explanation
Correct answer: C. Finance Lease
Under ASC 842, a lease is classified as a finance lease if it meets any one of five criteria (OWNS). Here, the lease term (75% of economic life) is greater than or equal to 75% of the asset's economic life, and the present value of lease payments (90% of fair value) is greater than or equal to 90% of the asset's fair value. Meeting either of these criteria classifies it as a finance lease.
Why the other options are wrong
- A. Sales-type lease is a lessor classification, not lessee.
- B. An operating lease would not meet any of the OWNS criteria.
- D. Direct financing lease is a lessor classification, not lessee.
Lessee Lease Classification (ASC 842)
Under ASC 842, a lessee classifies a lease as either a finance lease or an operating lease based on five criteria (OWNS test).
- Finance lease if any OWNS criteria are met.
- Operating lease if none of the OWNS criteria are met.
- OWNS: Ownership transfer, Written option to purchase, Net present value, Service life, Specialized asset.
Memory trick: Leases are tricky, remember OWNS to decide if it's FINANCE or OPERATING.