8.3 Lease Classification

ASC 842-10

25-1 An entity shall classify each separate lease component at the commencement date. An entity shall not reassess the lease classification after the commencement date unless the contract is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8. In addition, a lessee also shall reassess the lease classification after the commencement date if there is a change in the lease term or the assessment of whether the lessee is reasonably certain to exercise an option to purchase the underlying asset. When an entity (that is, a lessee or lessor) is required to reassess lease classification, the entity shall reassess classification of the lease on the basis of the facts and circumstances (and the modified terms and conditions, if applicable) as of the date the reassessment is required (for example, on the basis of the fair value and the remaining economic life of the underlying asset as of the date there is a change in the lease term or in the assessment of a lessee option to purchase the underlying asset or as of the effective date of a modification not accounted for as a separate contract in accordance with paragraph 842-10-25-8).

8.3.1 Relevance of Classification Determination

From the lessee’s perspective, leases are classified as either finance or operating leases. While the determination of lease classification does not affect the initial measurement of the lease, it will have a direct impact on items such as subsequent measurement and financial statement presentation and disclosure.

8.3.2 Classification Date

Lease classification is assessed on the lease commencement date, which is defined as the date on which the lessor makes the underlying asset available for use by the lessee (see Section 8.4.1). After the lease commencement date, a lessee would only be required to reassess lease classification when there is a change in the lease term (see Section 8.5.2.1), a change in the conclusion about the lessee’s assessment of whether it is reasonably certain to exercise an option to purchase the underlying asset (see Section 8.3.5.1.2), or a lease modification that is not accounted for as a separate contract (see Section 8.6.3).

Changing Lanes

Classification Date

Unlike ASC 842, ASC 840 required entities to classify leases on the basis of the facts and circumstances present at lease inception (i.e., the date of the lease agreement or commitment, if earlier) instead of at lease commencement (the date on which the lessor makes an underlying asset available to the lessee). For many entities, this is not a significant change, since there typically is not a significant lag between lease inception and lease commencement; however, in certain circumstances, the two dates significantly differ. In such cases, a lessee could theoretically arrive at different conclusions if facts and circumstances change between the dates (e.g., the fair value of the underlying asset or the discount rate). The diagram below illustrates the difference between lease inception and lease commencement.

8.3.3 Lease Classification Criteria

ASC 842-10

25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at lease commencement:

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

25-3 When none of the criteria in paragraph 842-10-25-2 are met:

A lessee shall classify the lease as an operating lease. . . .

25-3A Notwithstanding the requirements in paragraphs 842-10-25-2 through 25-3, a lessor shall classify a lease with variable lease payments that do not depend on an index or a rate as an operating lease at lease commencement if classifying the lease as a sales-type lease or a direct financing lease would result in the recognition of a selling loss.

25-7 See paragraphs 842-10-55-2 through 55-15 for implementation guidance on lease classification.

8.3.3.1 Overview of the Classification Criteria

A lessee’s lease classification has a direct impact on the subsequent accounting for a lease. From the lessee’s perspective, a lease will be classified as a finance lease when it meets one or more of the five criteria in ASC 842-10-25-2. When none of these criteria are met, the lease will be classified as an operating lease. A lessee performs its lease classification assessment at lease commencement (i.e., when the lessee obtains the right to use the asset).

By establishing the same five basic lease classification criteria for both lessors and lessees, the FASB attempted to achieve lease classification symmetry to a certain extent (i.e., a lease recorded as a finance lease by the lessee would generally be recorded as a sales-type lease by the lessor, or both parties would record an operating lease). Correct application of the lease classification criteria could result in asymmetrical classification of the same lease by the lessor and the lessee, however.

Circumstances in which such asymmetrical accounting may occur include:

The lessee’s use of its incremental borrowing rate instead of the rate implicit in the lease.
The inclusion in lease payments of third-party guarantees to the lessor.
A penalty that, from the lessee’s perspective, makes renewal of the lease reasonably certain but that is not similarly perceived by the lessor.
Differing assessments regarding the economic life or fair value of the underlying asset or the determination if the underlying asset will have an alternative use to the lessor at the end of the lease term.
Differing determinations of lessee options to renew or terminate the lease or purchase the underlying asset.
After the adoption of ASU 2021-05, leases with variable lease payments that do not depend on an index or rate and give rise to a day 1 loss for a lessor would need to be classified as an operating lease, while a lessee may classify the lease as a finance lease. See Section 17.3.1.8.1 for further details.

Connecting the Dots

Application of the Lease Classification Guidance at a Portfolio Level

It may be appropriate for a lessee to apply the lease classification criteria to a portfolio of leases under ASC 842 as long as the results do not materially differ from those achieved when the individual leases are classified on a lease-by-lease basis. We therefore believe that this approach would only be permitted when the portfolio includes leases that (1) are similar in nature (have similar underlying assets) and (2) have identical or nearly identical lease terms. See Section 8.2.2 for additional discussion of the application of the portfolio approach.

Bridging the GAAP

Dual-Model Versus Single-Model Approach for Lessees

ASC 842 includes a dual-model approach for lessees under which a lease is accounted for as either a finance lease or an operating lease in accordance with the lease classification criteria in ASC 842. In contrast, IFRS 16 prescribes a single-model approach for lessees under which all leases are accounted for in a manner similar to that under the U.S. GAAP accounting model for finance leases. Therefore, from the lessee’s perspective, lease classification is eliminated altogether under IFRS 16. See Appendix B for additional information about the differences between ASC 842 and IFRS 16.

8.3.3.2 Decision Tree on Determining Classification

8.3.3.3 Transfer of Ownership at the End of the Lease Term

ASC 842-10

25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at lease commencement:

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. . . .

55-4 The criterion in paragraph 842-10-25-2(a) is met in leases that provide, upon the lessee’s performance in accordance with the terms of the lease, that the lessor should execute and deliver to the lessee such documents (including, if applicable, a bill of sale) as may be required to release the underlying asset from the lease and to transfer ownership to the lessee.

55-5 The criterion in paragraph 842-10-25-2(a) also is met in situations in which the lease requires the payment by the lessee of a nominal amount (for example, the minimum fee required by the statutory regulation to transfer ownership) in connection with the transfer of ownership.

55-6 A provision in a lease that ownership of the underlying asset is not transferred to the lessee if the lessee elects not to pay the specified fee (whether nominal or otherwise) to complete the transfer is an option to purchase the underlying asset. Such a provision does not satisfy the transfer-of-ownership criterion in paragraph 842-10-25-2(a).

A lessee would “classify a lease as a finance lease” if ownership of the underlying asset is transferred to the lessee by the end of the lease term. For this criterion to be met, title must be transferred at little or no cost to the lessee shortly after the end of the lease term. In substance, such a transaction is akin to a financed purchase (i.e., the asset was purchased and financed through lease payments).

While the lessee accounting model has evolved since the issuance of FASB Statement 13 from a risks-and-rewards model (i.e., one based on benefits and risks) to a control-based model, certain of the underlying principles have not changed significantly. For example, when the lessee is required to pay only a nominal fee for title transfer, the lease would meet the criterion in ASC 842-10-25-2(a). If paying the fee (even when the fee is nominal) is optional, the lease would not explicitly meet this criterion but would still be evaluated under the criterion in ASC 842-10-25-2(b) — that is, the criterion indicating that the purchase option is reasonably certain to be exercised.

8.3.3.4 Purchase Option Reasonably Certain to Be Exercised

ASC 842-10

25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at lease commencement: . . .

b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. . . .

A lease would be classified as a finance lease if, at lease commencement, the lessee deems it to be reasonably certain that it will exercise a purchase option by the end of the lease term.

“Reasonably certain” is meant to be a high threshold. That is, it would be a higher threshold than “probable” under ASC 450. (See Section 5.2.2 for additional discussion of the application of the “reasonably certain” criteria.) ASC 842 includes certain factors that a lessee should evaluate when determining whether exercise of a purchase option is reasonably certain, including contract-based, asset-based, entity-based, and market-based factors. Generally speaking, after considering these factors, the lessee should evaluate whether it has an economic compulsion or incentive to exercise its purchase option, since this is a strong indicator that exercise of the option is reasonably certain.

ASC 842-10-55-26 includes a list of economic factors (not all-inclusive) for an entity to consider when evaluating whether the exercise of an option is reasonably certain. Such an evaluation must include an assessment of whether an economic compulsion exists.

The examples below demonstrate scenarios in which the lessee’s exercise of its purchase option would be reasonably certain. In addition to the below discussion, Examples 23 and 24 in ASC 842-10 (reproduced in Section 8.9.2) illustrate the accounting for purchase options.

Example 8-2

Entity P leases a tractor that it may purchase for $10,000 at the end of the lease term. The fair value of the tractor is expected to be $20,000 when the lease term ends. Further, P has provided the lessor with a residual value guarantee of $25,000 in the event that P does not exercise the purchase option.

Example 8-3

Entity U leases an airplane in which it installs luxury seating and a gold-plated cocktail bar, both of which add significant value to the airplane. At the end of the lease term in three years, U may purchase the airplane for an amount that is commonly paid for an airplane that does not have luxury seating and a cocktail bar. The remaining useful life of the seating and bar assets extends 20 years after the noncancelable lease term.

8.3.3.5 Major Part of the Remaining Economic Life

ASC 842-10

25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at lease commencement: . . .

c. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease. . . .

55-2 When determining lease classification, one reasonable approach to assessing the criteria in paragraphs 842-10-25-2(c) through (d) and 842-10-25-3(b)(1) would be to conclude:

Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset. . . .

A lessee would “classify a lease as a finance lease [when the] lease term is for the major part of the remaining economic life of the underlying asset” (i.e., the economic life that remains on the commencement date versus the economic life when the asset is new). The ASC master glossary defines economic life as “[e]ither the period over which an asset is expected to be economically usable by one or more users or the number of production or similar units expected to be obtained from an asset by one or more users.” Note that a lease would not be subject to the “major part of the economic life” criterion if (1) the lease commences at or near the end of the economic life of the underlying asset (see discussion below in Section 8.3.3.5.1) or (2) the lease involves facilities owned by a government unit or authority and the remaining economic life of the underlying asset is indeterminate (see discussion in Section 8.3.5.3).

Connecting the Dots

Use of ASC 840’s Bright-Line Thresholds for Lease Classification

The lease classification tests under the legacy leasing guidance in ASC 840 involved “bright lines” (e.g., the 90 percent fair value test). That is, under ASC 840, a lease was classified as a capital lease if the lease term was 75 percent or more of the remaining economic life of an underlying asset or if the sum of the present value of the lease payments and the present value of any residual value guarantees amounted to 90 percent or more of the fair value of the underlying asset. However, under the lease classification guidance in ASC 842-10-25-2, entities are no longer required to assess certain quantitative bright-line thresholds when classifying a lease. Nevertheless, they are still permitted to use quantitative thresholds when classifying a lease under ASC 842.

In fact, the implementation guidance in ASC 842-10-55 states that a reasonable approach to applying the lease classification criteria in ASC 842 is to use the same bright-line thresholds as those in ASC 840. ASC 842-10-55-2 states the following:

When determining lease classification, one reasonable approach to assessing the criteria in paragraphs 842-10-25-2(c) through (d) and 842-10-25-3(b)(1) would be to conclude:

Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.
Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.

On the basis of this implementation guidance, we would not object if an entity were to apply ASC 840’s bright-line thresholds when classifying a lease under ASC 842. We would expect that under such an approach, an entity would classify a lease in accordance with the quantitative result. That is, if an entity applies ASC 840’s bright-line thresholds and determines that a lease term is equal to 76 percent of an asset’s useful life, the entity should classify the lease as a finance lease. The entity should not attempt to overcome the assessment with qualitative evidence to the contrary. Likewise, if the same entity determines that a lease term is equal to 74 percent of an asset’s useful life, the entity should classify the lease as an operating lease. We would expect that if an entity decides to apply the bright-line thresholds in ASC 840 when classifying a lease, the entity would apply those thresholds consistently to all of its leases.

8.3.3.5.1 Estimated Economic Life Versus Depreciable Life

Generally, we would expect the economic life of an asset to correspond to its depreciable life used for financial reporting. In accordance with ASC 360, depreciable life is calculated on the basis of the asset’s useful life, which is similar but not identical to the economic life an entity uses in performing the lease classification test.

The ASC master glossary defines useful life as the “period over which an asset is expected to contribute directly or indirectly to future cash flows” and economic life as “[e]ither the period over which an asset is expected to be economically usable by one or more users or the number of production or similar units expected to be obtained from an asset by one or more users.”

The objective of determining either the useful life or economic life of an asset is to identify the period over which the asset will provide benefit. The asset’s useful life represents the period over which the reporting entity will benefit from use of the asset. In contrast, the economic life represents the period over which “one or more users” will benefit from use of the asset. Therefore, the asset’s estimated depreciable life pertains to the intended use by the current owner, whereas the estimated economic life may encompass both the current and future owners of the asset.

This difference between the two definitions is not relevant in many cases since a single entity (the current owner) is often expected to use an asset for its entire life. However, depending on the facts and circumstances, it may sometimes be appropriate for an entity to use an estimated economic life for lease classification purposes that is longer than the asset’s estimated depreciable life.

Example 8-4

Company X, an automobile lessor, routinely purchases automobiles that are economically usable for seven years. Company X leases the automobiles to lessees for three years and sells the automobiles after the end of the three-year lease term. Company X may have a supportable basis for using a three-year depreciable life (with a correspondingly higher salvage value) for financial reporting purposes but a seven-year economic life for lease classification purposes.

8.3.3.5.2 Economic Life Considerations for Land

Land has an infinite economic life and therefore could never meet the criterion in ASC 842-10-25-2(c). Thus, the estimated economic life test cannot be applied to a lease that only involves land or when land is treated as a separate lease component.

8.3.3.5.3 At or Near the End of the Economic Life

When an underlying asset in a lease is at or near the end of its economic life, it is not subject to the economic life test. This is consistent with the guidance in ASC 842-10-25-2(c), which states, in part:

However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

Further, ASC 842-10-55-2 indicates that a “reasonable approach” to determining whether an underlying asset is at or near the end of its economic life would be evaluating whether the “commencement date . . . falls within the last 25 percent of the total economic life of the underlying asset.”

8.3.3.5.4 Considerations Related to the Predominant Asset

ASC 842-10

25-5 If a single lease component contains the right to use more than one underlying asset (see paragraphs 842-10-15-28 through 15-29), an entity shall consider the remaining economic life of the predominant asset in the lease component for purposes of applying the criterion in paragraph 842-10-25-2(c).

A lease contract may include a single lease component that relies on the use of more than one underlying asset. For example, pieces of equipment that have different remaining economic lives may be leased in the aggregate, but a lessee may conclude that there is only a single lease component on the basis of the criteria in ASC 842-10-15-28. (See Chapter 4 for additional information on separate lease components.) In such cases, an entity must consider the remaining economic life of the predominant asset in the overall lease component when applying the classification criterion in ASC 842-10-25-2(c).

Regarding the assessment of the predominant asset in a lease component, paragraph BC74 of ASU 2016-02 states, in part:

The Board noted that assessing the predominant asset in a lease component that includes multiple underlying assets will be straightforward in most cases. That is, the assessment is a qualitative one that requires entities to conclude on what is the most important element of the lease, which should be relatively clear in most cases. The Board also noted that if an entity is unable to identify the predominant asset, it may indicate that there is more than one separate lease component in the contract.

8.3.3.6 Substantially All of the Fair Value of the Underlying Asset

ASC 842-10

25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at lease commencement:

d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset. . . .

55-2 When determining lease classification, one reasonable approach to assessing the criteria in paragraphs 842-10-25-2(c) through (d) and 842-10-25-3(b)(1) would be to conclude: . . .

c. Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.

As noted above, a lessee would classify a lease as a finance lease if, at lease commencement, the “present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments . . . equals or exceeds substantially all of the fair value of the underlying asset.” When performing this classification test, the lessee should include any lease payments made to, or lease incentives received from, the lessor before or on the commencement date of the lease.

In the calculation of the present value of the lease payments and any residual value guaranteed by the lessee, the discount rate used by the lessee is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate (see Chapter 7 for additional information on a lessee’s determination of its discount rate).

Connecting the Dots

Evaluating “Substantially All”

Under ASC 840, there were many opportunities to create highly structured leases. Specifically, many leases were designed so that the present value of lease payments would be 89.9 percent of the fair value.

One of the most notable aspects of ASC 842 is the exclusion of “bright lines” (e.g., the 90 percent fair value test) from the lease classification tests. However, ASC 842-10-55-2 acknowledges that 90 percent may be an appropriate threshold for the “substantially all” criterion.

Because the FASB takes a more principles-based approach to classification in ASC 842, we do not believe that an 89.9 percent present value would necessarily result in an operating lease classification. This would, however, depend on the entity’s accounting policies, which should be consistently applied. See Section 8.3.3.5 for more information.

Considerations Related to Residual Value Guarantees

The ASC master glossary defines a residual value guarantee as follows:

A guarantee made to a lessor that the value of an underlying asset returned to the lessor at the end of a lease will be at least a specified amount.

Irrespective of what the fair value of the underlying asset is expected to be at the end of the lease term, a residual value guarantee should be included under this lease classification criterion at the maximum required deficiency that a lessee may be required to pay to the lessor at the end of the lease term.

In addition, there is a significant difference between residual guarantees related to determining lease payments for lease measurement purposes and those related to evaluating lease classification. For lease payments, a lessee would only include the amount that it is probable it will owe at the end of the lease term under a residual value guarantee. In contrast, for lease classification purposes, a lessee would include the entire residual value guarantee (i.e., both the portion of the residual value guarantee that is considered a lease payment and any residual value guaranteed by the lessee that is not already reflected in such payments).

Example 8-5

Company A enters into a lease agreement with Supplier for the use of a backhoe for a five-year period. Supplier estimates that the residual value of the backhoe at the end of the lease term will be $150,000, which is based on an expected 3,000 hours of use during the term. As part of the lease contract, A provides a residual value guarantee under which it is required to compensate the lessor for any difference if the value of the backhoe at the end of the lease is less than $140,000 (i.e., the maximum A could be required to pay under the residual value guarantee is $140,000). At lease commencement, A concludes that it expects to use the backhoe for an estimated 4,500 hours during the lease term and therefore expects the value of the backhoe at the end of the term, on the basis of the excess wear and tear from additional usage, to be $135,000. As a result, A determines that the amount that it is probable it will owe to Supplier at the end of the lease term is $5,000, which reflects the $140,000 that the lessee guaranteed less the expected value of $135,000 on the basis of the expected usage of the backhoe over the lease term.

Lease Payment Used for Lease Measurement Purposes

In accordance with ASC 842-10-30-5(f), $5,000 would be considered a lease payment for A, since this would be the amount that it is probable A would owe under the residual value guarantee.

Lease Classification

In accordance with ASC 842-10-25-2, A would include $140,000 in the “substantially all of the fair value” classification test when evaluating lease classification. The $140,000 represents the residual value of the backhoe that A is guaranteeing at the end of the lease term (i.e., this amount would include both the $5,000 included in the lease payments and the $135,000 of potential additional deficiency not included in the lease payments).

Changing Lanes

Consideration of Nonperformance-Related Default Provisions

Some lease agreements contain nonperformance-related default provisions that may require the lessee to purchase the leased asset or make another payment if the lessee is in default under such provisions. Common examples of these provisions include clauses related to bankruptcy, changes in control, and material adverse changes. Under ASC 840, these provisions needed to be carefully considered and often directly affected the classification of the lease. Specifically, ASC 840-10-25-14 listed four conditions that needed to be satisfied for the default provisions not to affect lease classification:

The default covenant provision is customary in financing arrangements.
The occurrence of the event of default is objectively determinable (for example, subjective acceleration clauses would not satisfy this condition).
Predefined criteria, related solely to the lessee and its operations, have been established for the determination of the event of default.
It is reasonable to assume, based on the facts and circumstances that exist at lease inception, that the event of default will not occur.

If any of the above conditions were not met under ASC 840, a lessee determining the lease classification was required to include, in its minimum lease payments, the maximum potential amount that it could owe under the default provision. This requirement applied to both the lessee’s and the lessor’s classification evaluation.

The guidance in ASC 840 on nonperformance-related default provisions was not carried over to ASC 842. Thus, an entity no longer has to include these amounts in its lease payments when determining its lease classification from the perspective of either the lessee or the lessor.

While these provisions are no longer expected to affect the classification of the lease, it will nonetheless be important to monitor compliance with the provisions since their occurrence can trigger payment obligations for the lessee. We believe that these payments will often represent variable lease payments given that they arise on the basis of changes in facts and circumstances occurring after the commencement date of the lease. See Section 6.9.1 for guidance on variable lease payments that do not depend on an index or rate and Section 6.10 for guidance on subsequent measurement of lease payments. The guidance on variable lease payments in that section is likely to apply when the default remedy is a one-time payment incurred in the period in which the default provision is violated. If, instead of a one-time payment, the remedy calls for increased payments over some future period (e.g., the remaining term of the lease), it will most likely be necessary to remeasure the lease. See Section 8.5.3 for a discussion of the accounting treatment when variable payments become lease payments on the basis of the resolution of a contingency.

Classification of the Land Component Under ASC 840

ASC 842 diverges from ASC 840 in how both lessees and lessors allocate consideration and classify the land component of a lease arrangement when the entity accounts for the right to use land separately from the other components in the contract. For more information about how this guidance differs, see Section 4.2.2.

8.3.3.6.1 Impact of Portfolio Residual Value Guarantees on Lessee’s Lease Classification

Lessees often enter into lease agreements to lease multiple similar assets from lessors. In these circumstances, lessees will often guarantee the residual value for the group of assets being leased (e.g., the portfolio of underlying assets) rather than that for each individual underlying asset. ASC 842-10-55-10 states that a lessor should not2 consider residual value guarantees of a portfolio of underlying assets when evaluating the lease classification criteria, since “[r]esidual value guarantees of a portfolio of underlying assets preclude a lessor from determining the amount of the guaranteed residual value of any individual underlying asset within the portfolio.”

ASC 842 does not explicitly address whether a lessee should consider a PRVG when classifying individual leases within a portfolio. However, when performing the lease classification test in ASC 842-10-25-2(d), the lessee should take into account “any residual value guaranteed by the lessee that is not already reflected in the lease payments.” This criterion reflects the maximum amount that the lessee could be obligated to pay under the lease arrangement, which should include residual value guarantees regardless of whether they are based on a portfolio or on an individual asset. If residual value guarantees were excluded, the lessee’s full potential obligation under the lease arrangement would not be depicted.

We believe that there are two acceptable approaches lessees can use to apportion a PRVG to the individual leases in a portfolio: (1) the all-in approach and (2) the pro rata approach. The all-in approach is appropriate in all circumstances, while the pro rata approach is acceptable only if the leases are substantially similar in such a way that they meet the following criteria (these criteria are similar to those in Section 9.2.1.4.2, which addresses PRVGs from a lessor’s perspective):

The individual leases in the portfolio commence and end at the same time.
The leased assets are physically similar to each other.
The variability associated with the expected residual values is expected to be highly correlated (i.e., one asset’s residual value is expected to be similar to that of the other assets’ residual values).

The following are some additional details about the all-in and pro rata approaches:

All-in approach — This approach is predicated on the fact that the lessee has an unavoidable obligation to provide a residual value guarantee on the portfolio of leased assets. In addition, the lessee effectively has control of each individual asset through its unilateral right to choose which (or how much) of the underlying assets subject to the PRVG will be consumed in accordance with paragraph BC71(d) of ASU 2016-02. Under this approach, a lessee will allocate the full amount of the PRVG to each lease within the portfolio.
Pro rata approach — Under this approach, the PRVG amount will be spread among the individual leases within the portfolio. That is, the lessee will apply the PRVG on a pro rata basis in relation to the expected residual value of each underlying asset at the end of the lease term, which should be a similar amount for each underlying asset, provided that the criteria above are met.

Example 8-6

Lessee enters into a master lease of four substantially similar pieces of equipment. The following facts apply to each item of equipment at lease commencement (which is the same date for all equipment):

Noncancelable lease term of five years.
Fixed lease payments of $3,100 per year, payable in arrears.
No transfer of ownership.
No renewal, purchase, or termination options.
Fair value of $24,000 for each piece of equipment.
Total economic life of each piece of equipment is 10 years.
Remaining economic life of each piece of equipment is eight years.
There is an alternative use to Lessor at the end of the lease.
The estimated residual value at the end of the lease is $7,500 per piece of equipment.
Lessee’s incremental borrowing rate is 3.5 percent (the implicit rate cannot be readily determined).
The present value of lease payments for each lease, excluding allocated residual value guarantees, is $13,997.
There are no initial direct costs.

Lessee provides a guarantee that the residual value of the four pieces of equipment will be $30,000 in the aggregate at the end of the lease and uses the bright-line threshold of 90 percent when performing the present value test. The tables below illustrate the inclusion of the PRVG for lease classification by using the present value test under the (1) all-in approach and (2) pro rata approach.

All-In Approach

Pro Rata Approach

8.3.3.6.2 First-Dollar-Loss Residual Value Guarantee

The guidance in ASC 840-10-55-9 was clear that a lessee should include the maximum amount that it could be required to pay under a residual value guarantee when determining the minimum lease payments to be used in the assessment of lease classification in accordance with ASC 840-10-25-1(d). Specifically, ASC 840-10-55-9 stated, in part:

If a lease limits the amount of the lessee’s obligation to make up a residual value deficiency to an amount less than the stipulated residual value of the leased property at the end of the lease term, the amount of the lessee’s guarantee to be included in minimum lease payments under paragraph 840-10-25-6(b) shall be limited to the specified maximum deficiency the lessee can be required to make up.

It is common for lease arrangements to limit (i.e., cap) the amount of residual value guarantee that the lessee would be required to pay. Such an arrangement, as described in the example below, is commonly referred to as a “first-dollar-loss residual value guarantee,” since any initial deficiency below the guaranteed residual value must first be borne by the lessee.

Example 8-7

A lessee and lessor enter into a lease arrangement for use of an office building. The lessee agrees to a residual value guarantee of $450,000, subject to a limit of $390,000 representing a first-dollar-loss residual value guarantee. At the end of the lease term, the lessee is only obligated to reimburse the lessor on a dollar-for-dollar basis for any shortfall below $450,000 in the amount received upon sale of the property up to $390,000. In other words, if the lessor cannot sell the property for $450,000 or more, the lessee would be required to compensate the lessor for each dollar below $450,000, up to a maximum of $390,000. The lessor only has a remaining residual risk in the property in the event that the sales price drops below $60,000.

First-dollar-loss residual value guarantees should be treated in the same manner in the assessment of lease classification under ASC 842 as they were under ASC 840. This conclusion is supported by the discussion in paragraph BC71(d) of ASU 2016-02. Therefore, the lessee should include in the lease classification test the maximum payment that it could be required to pay to the lessor under the leasing arrangement at the end of the lease term. In the example above, because the lessee will never be required to pay more than $390,000, only $390,000 should be included in the lease payments for lease classification purposes.

As discussed in Section 6.7, a lessee considers its full exposure under a residual value guarantee when classifying its leases; however, a lessee only considers the amount likely to be owed under the residual value guarantee when measuring its lease payments. This measurement approach represents a departure from ASC 840, which required the use of the full exposure for both classification and measurement (to the extent that a lease was classified as a capital lease).

8.3.3.6.3 Impracticable to Determine Fair Value

ASC 842-10

55-3 In some cases, it may not be practicable for an entity to determine the fair value of an underlying asset. In the context of this Topic, practicable means that a reasonable estimate of fair value can be made without undue cost or effort. It is a dynamic concept; what is practicable for one entity may not be practicable for another, what is practicable in one period may not be practicable in another, and what is practicable for one underlying asset (or class of underlying asset) may not be practicable for another. In those cases in which it is not practicable for an entity to determine the fair value of an underlying asset, lease classification should be determined without consideration of the criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1).

We believe it would be unlikely that a lessee would not be able to determine the fair value of an underlying asset. Lessees that consider ASC 842-10-55-3 to be applicable to their facts and circumstances should consult their accounting advisers.

8.3.3.6.4 Lessee’s Determination of the Fair Value of a Portion of a Larger Asset

In determining whether to classify a lease as a finance lease, a lessee must determine whether “the present value of the sum of the lease payments . . . equals or exceeds substantially all of the fair value of the underlying asset” in accordance with ASC 842-10-25-2(d) (see Section 8.3.3.6). Accordingly, when classifying the lease (i.e., as a finance or operating lease), the lessee must determine the fair value of the underlying asset — for use in the fair value test — at the level associated with the identified lease component. This level could be a portion of a larger asset, such as a floor of an office building. If it is impracticable for a lessee to determine the fair value of an underlying asset in accordance with ASC 842-10-55-3, the lessee should assess the lease classification without considering the criterion in ASC 842-10-25-2(d). In this context, “practicable” means that fair value can be reasonably estimated without undue cost or effort.

Consider an example in which a lessee leases space on a cell tower (e.g., a hanger) from an owner/lessor. The individual hanger is the unit of account from a leasing perspective. A similar situation may arise when a lessee leases an individual floor of a building from an owner/lessor. As stated above, when classifying the lease, the lessee must determine the fair value of the underlying asset for use in the fair value test — which would be at the level of the individual hanger or individual floor in these examples — unless it is impracticable to do so.

While ASC 842 does not address the determination of the fair value of a larger asset, we believe that a lessee can use various methods to make this determination, depending on the facts and circumstances. To the extent that the lessee is able to determine the fair value of the entire larger asset (e.g., a cell tower or building, as described in the examples above), it may be appropriate to use an “allocation approach” to allocate the fair value of the larger asset to the respective portions of the larger asset that are being leased.

For example, the fair value of the larger asset could be proportionately allocated — on the basis of the perceived value of the individual leasable spaces — to the individual portions of the larger asset. When this method is used, other conditions that may be more representative of the fair value of the leased asset should be considered. In a building, for instance, higher floors are often more desirable, have a higher stand-alone selling price, and are leased at a higher cost to the lessee than lower floors. In such circumstances, use of an appropriate allocation method would result in the allocation of a greater fair value to the higher floors. Such an allocation would better represent the economics of the individual lease arrangements and better reflect the fair value of each respective portion.

Likewise, we believe that an entity that is estimating the fair value of a portion of a larger asset should consider the intended use of the asset. It is also important not to confuse relative fair value with relative construction or replacement costs. In the cell tower example described above, while the percentage of the costs for the individual hangers may not be disproportionately high compared with the cost of the overall structure, it is likely that the hangers in the aggregate account for most of the fair value of the tower since they represent its revenue-producing parts. In other words, we would sometimes expect the fair value of discrete portions of a larger asset to be disproportionate compared with that of the entire asset on a space or square-footage basis when the relative revenue-producing potential of the discrete portions is taken into account.

We believe that a lessee should generally be able to determine the fair value of a portion of an underlying asset. Further, we would expect that a lessee that can estimate the fair value of the larger asset (which will often be the case) would typically be able to reasonably allocate an appropriate percentage of that fair value to the portion being leased without undue cost or effort.

8.3.3.6.5 Investment Tax Credits

ASC 842-10

55-8 When evaluating the lease classification criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1), the fair value of the underlying asset should be reduced by any related investment tax credit retained by the lessor and expected to be realized by the lessor.

When an entity applies the “present value” test, the fair value of the underlying asset would be reduced by any ITCs since these are linked to the ownership of the asset and are retained by the lessor.

8.3.3.7 Underlying Asset Is Specialized and Has No Alternative Use to the Lessor at the End of the Lease Term

ASC 842-10

25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at lease commencement: . . .

e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

55-7 In assessing whether an underlying asset has an alternative use to the lessor at the end of the lease term in accordance with paragraph 842-10-25-2(e), an entity should consider the effects of contractual restrictions and practical limitations on the lessor’s ability to readily direct that asset for another use (for example, selling it or leasing it to an entity other than the lessee). A contractual restriction on a lessor’s ability to direct an underlying asset for another use must be substantive for the asset not to have an alternative use to the lessor. A contractual restriction is substantive if it is enforceable. A practical limitation on a lessor’s ability to direct an underlying asset for another use exists if the lessor would incur significant economic losses to direct the underlying asset for another use. A significant economic loss could arise because the lessor either would incur significant costs to rework the asset or would only be able to sell or re-lease the asset at a significant loss. For example, a lessor may be practically limited from redirecting assets that either have design specifications that are unique to the lessee or that are located in remote areas. The possibility of the contract with the customer being terminated is not a relevant consideration in assessing whether the lessor would be able to readily direct the underlying asset for another use.

A lessee would “classify a lease as a finance lease” if, at lease commencement, the “underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.” The basis for this determination is that when an underlying asset has no alternative use to the lessor at the end of a lease term, it is presumed that the lessee will consume all (or substantially all) of the benefits of the asset.

Changing Lanes

New Lease Classification Criterion

The new lease classification criterion in ASC 842-10-25-2(e) has not been previously applied in practice under U.S. GAAP and is not expected to frequently be met in isolation. We do not believe that this criterion should be interpreted as applying to situations in which the underlying asset is near the end of its economic life and the lessee, by virtue of the lease, therefore has obtained all of the use of the asset so that it has “no alternative use.” Rather, the application of this criterion is intended to identify situations in which the lessee uses all of the asset’s economic benefits because the asset is so specialized for that particular lessee that the lessor would not be expected to generate economic benefit from the asset’s use outside of the lease.

Connecting the Dots

Meeting the Criterion in ASC 842-10-25-2(e)

It is unlikely that the criterion in ASC 842-10-25-2(e) would be met in isolation because a lessor economically would not enter into an arrangement in which it would not be compensated to obtain a worthless asset at the end of a lease term. However, if a lease is structured with entirely variable lease payments (and the lease therefore does not meet the criterion in ASC 842-10- 25-2(d)), the lease may be more likely to meet the criterion in ASC 842-10-25-2(e) in isolation.

8.3.4 Classification Reassessment Requirements

After the lease commencement date, if a lease is modified and that modification is not accounted for as a separate contract, both the lessee and the lessor must reassess lease classification as of the effective date of the modification. Similarly, a lessee must also reassess lease classification when there is a change in the lease term or in the lessee’s conclusion about whether exercise of a purchase option is reasonably certain. When reassessing lease classification, an entity should consider the facts and circumstances that exist as of the reassessment date, as required by ASC 842-10-25-1 and ASC 842-10-25-9. For example, an entity would consider the fair value and the remaining economic life of the underlying asset as of the effective date of a modification not accounted for as a separate contract or (for a lessee) as of the date on which there is a change in the lease term or in the lessee’s conclusion regarding the exercise of a purchase option.

When performing the fair value classification test in reassessing the classification of a lease, an entity should include all the remaining lease payments (as defined by ASC 842-10-30-5), along with any residual value guaranteed by the lessee that is not already reflected in the remaining lease payments, in accordance with ASC 842-10-25-2(d). In addition, ASC 842-10-25-1 states, in part, “When an entity (that is, a lessee or lessor) is required to reassess lease classification, the entity shall reassess classification of the lease on the basis of the facts and circumstances (and the modified terms and conditions, if applicable) as of the date the reassessment is required.” The facts and circumstances as of the date of the lease classification reassessment include the unamortized balance of any prepaid or accrued lease payments and the unamortized balance of any incentives paid by the lessor to the lessee. That is, if the unamortized balances were not present (e.g., a prepaid lease payment did not exist or was never required to be paid), the modification would most likely have resulted in different negotiated terms. Accordingly, an entity should consider the unamortized balance of any prepaid items when performing the fair value classification test. As discussed in Section 8.3.3.6, an entity also considers such prepaid items when classifying a lease at commencement.

Example 8-8

Lessee enters into a 10-year lease of a nonspecialized asset. Lease payments are $50,000 per month, payable at the beginning of the month, plus a one-time payment at lease commencement of $1,000,000. The lease does not transfer ownership of the underlying asset or grant Lessee an option to purchase the underlying asset or renew the lease. At lease commencement, the remaining economic life of the underlying asset is 20 years, and the fair value of the underlying asset is $6,500,000. Lessee’s incremental borrowing rate is 3 percent. At lease commencement, the sum of the present value of the lease payments (including the one-time payment at lease commencement) is $6,191,033, which is substantially all of the fair value of the underlying asset (i.e., 95.2 percent). Accordingly, the lease is classified as a finance lease.

At the beginning of year 2, the lease is modified in such a way that the monthly lease payments are reduced by 5 percent (i.e., remaining lease payments are $47,500 per month). The fair value of the underlying asset is $5,750,000. The unamortized balance of the prepaid lease payment (included in the ROU asset) is $900,000. Lessee’s incremental borrowing rate is 3.1 percent. As of the effective date of the modification, the sum of the present value of the lease payments (including the unamortized balance of the prepaid lease payment) is $5,383,070, which is substantially all of the fair value of the underlying asset (i.e., 93.6 percent). Accordingly, the lease continues to be classified as a finance lease.

It would be inappropriate for Lessee to disregard the unamortized balance of the prepaid lease payment when determining the present value of the lease payments, since this balance is part of the consideration in the arrangement that is associated with the ongoing lease as of the effective date of the modification. The sum of the present value of the remaining lease payments (without considering the unamortized balance of the prepaid lease payment) is $4,483,070, which is not substantially all of the fair value of the underlying asset (i.e., 78 percent). Accordingly, if Lessee would have disregarded the unamortized balance of the prepaid lease payment, the lease classification would have inappropriately changed to an operating lease classification.

Connecting the Dots

Consideration of Facts and Circumstances Existing as of the Reassessment Date

ASU 2016-02, as originally drafted, was not clear on whether a lessee is required to reassess lease classification on the basis of the facts and circumstances existing as of the reassessment date. In response to stakeholder feedback on this matter, in July 2018, the FASB issued ASU 2018-10, which, among other amendments, added the following passage to ASC 842-10-25-1:

When an entity (that is, a lessee or lessor) is required to reassess lease classification, the entity shall reassess classification of the lease on the basis of the facts and circumstances (and the modified terms and conditions, if applicable) as of the date the reassessment is required (for example, on the basis of the fair value and the remaining economic life of the underlying asset as of the date there is a change in the lease term or in the assessment of a lessee option to purchase the underlying asset or as of the effective date of a modification not accounted for as a separate contract in accordance with paragraph 842-10-25-8).

See Section 17.3 for additional information on FASB standard-setting activity related to ASC 842.

8.3.5 Other Considerations Related to Lease Classification

8.3.5.1 Lease of an Acquiree

ASC 842-10

Pending Content (Transition Guidance: ASC 805-60-65-1)

55-11 In a business combination or an acquisition by a not-for-profit entity, the acquiring entity should retain the previous lease classification in accordance with this Subtopic unless there is a lease modification and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8. A joint venture formation accounted for in accordance with Subtopic 805-60 should apply the guidance in this paragraph applicable to the acquiring entity in a business combination. The joint venture should be viewed as analogous to the acquiring entity in a business combination, and any recognized businesses and/or assets should be viewed as analogous to an acquiree.

ASC 805-20

25-28A The acquirer shall recognize assets and liabilities arising from leases of an acquiree in accordance with Topic 842 on leases (taking into account the requirements in paragraph 805-20-25-8(a)).

25-28B For leases for which the acquiree is a lessee, the acquirer may elect, as an accounting policy election by class of underlying asset and applicable to all of the entity’s acquisitions, not to recognize assets or liabilities at the acquisition date for leases that, at the acquisition date, have a remaining lease term of 12 months or less. This includes not recognizing an intangible asset if the terms of an operating lease are favorable relative to market terms or a liability if the terms are unfavorable relative to market terms.

As noted above, for leases acquired as the result of “a business combination or an acquisition by a not-for-profit entity,” lease classification will not be revisited unless the lease contract is modified “and that modification is not accounted for as a separate contract.” If there is a modification as of or after the business combination, the acquiree will need to reevaluate lease classification in accordance with the lease modification guidance (see Section 8.6 for additional considerations).

For more information about accounting for leases acquired in a business combination, see Section 4.3.11 of Deloitte’s Roadmap Business Combinations.

8.3.5.1.1 Accounting for Leases Acquired in a Business Combination

8.3.5.1.1.1 Classification

An acquiree’s classification of its leases is not reconsidered in a business combination unless the lease agreement is modified as part of the business combination and that modification is not accounted for as a separate contract. Therefore, the acquiree’s classification of its lease agreements generally carries over to the acquiring entity.

If the terms of a lease agreement are modified as part of the business combination and the modification is not accounted for as a separate contract in accordance with ASC 842-10-25-8, the lease is classified as of the acquisition date by using the modified terms.

8.3.5.1.1.2 Recognition

In accordance with ASC 805-20-25-28A, the acquirer should recognize assets and liabilities arising from leases (both operating and financing type) of an acquiree in accordance with ASC 842. Notwithstanding the requirement in ASC 805-20-25-28A, an acquirer may elect, as an accounting policy, not to recognize assets and liabilities arising from leases of an acquiree if both of the following conditions are met: (1) the acquiree is the lessee and (2) the remaining term of the lease, as of the acquisition date, is one year or less.

8.3.5.1.1.3 Measurement

The acquirer in a business combination should apply the guidance in paragraph BC415 of ASU 2016-02 when measuring the assets and liabilities resulting from leases (both operating and financing type) in which the acquiree is a lessee. Paragraph BC415 of ASU 2016-02 states:

The Board decided that when the acquiree in a business combination is a lessee, the acquirer should measure the acquiree’s lease liability at the present value of the remaining lease payments as if the acquired lease were a new lease at the date of acquisition. Measuring the acquired lease as if it were a new lease at the date of acquisition includes undertaking a reassessment of all of the following:

The lease term
Any lessee options to purchase the underlying asset
Lease payments (for example, amounts probable of being owed by the lessee under a residual value guarantee)
The discount rate for the lease.

The acquiree’s right-of-use asset should be measured at the amount of the lease liability, adjusted for any off-market terms (that is, favorable or unfavorable terms) present in the lease. Prepaid or accrued rent should not be recognized because such amounts do not meet the definition of an asset or a liability in Concepts Statement 6 under the acquisition method of Topic 805, Business Combinations. Instead, the remaining lease payments required under the terms of the lease are considered in evaluating whether the terms of the lease are favorable or unfavorable at the acquisition date.

Further, as discussed in paragraph BC416 of ASU 2016-02, the Board had considered whether, when the acquiree is a lessee, the acquirer should apply the general principle in ASC 805 and therefore measure the ROU assets and lease liabilities at fair value. However, the Board believed that the costs of obtaining information about fair value in such circumstances would outweigh the benefits. Rather, the Board decided that the acquirer should reassess the key inputs (i.e., lease term, purchase options, lease payments, and discount rate) as of the acquisition date to measure the ROU asset and lease liability.

For more information about accounting for leases acquired in a business combination, see Section 4.3.11.1 of Deloitte’s Roadmap Business Combinations.

8.3.5.1.2 Accounting for Leases Acquired in a Business Combination When It Is Reasonably Certain That the Acquirer Will Exercise a Purchase Option in an Acquired Operating Lease

The acquirer in a business combination retains the original classification of an acquired lease if the lease is not modified as a result of the acquisition. Upon acquisition, the acquirer should measure the acquired lease as if it were a new lease and recognize a lease liability and ROU asset in an amount determined, in part, on the basis of the remaining lease term and remaining lease payments.3 These payments include the lease payment associated with a purchase option that the acquirer is deemed reasonably certain to exercise, regardless of whether the acquiree concluded that such exercise was reasonably certain to occur at lease commencement. Thus, there may be circumstances in which exercise of a purchase option is determined to be reasonably certain but the lease is classified as an operating lease because it retains its legacy classification.4

Consider the following scenario:

Company P obtains control of Company D in an acquisition that is accounted for as a business combination under ASC 805-10.
Acquired assets include an existing lease for office space in which D is the lessee.
The office space lease has a fixed-price purchase option; D determined that exercise of the option at lease commencement was not reasonably certain.
The lease is classified as an operating lease and the lease is not modified as a result of the business combination. Accordingly, P retains the operating lease classification in accordance with ASC 842-10-55-11.
As of the acquisition date, the lease has a remaining contractual lease term of four years, with no termination options. The remaining useful life of the asset as of the acquisition date is 10 years.
The annual lease payments are $50,000 for the lease’s remaining contractual term. The lease payments are deemed consistent with current market rates.
The lease has a purchase option at the end of the contractual term for an amount of $150,000. Company P has determined that it is reasonably certain that it will exercise this purchase option upon completion of the contractual term.
Company P’s incremental borrowing rate is 5 percent as of the acquisition date.

Upon acquisition, P will record a lease liability and ROU asset of $300,703 on the basis of the present value of the remaining annual lease payments and the exercise price of the purchase option. Because control of the leased asset will ultimately be transferred to P upon exercise of the purchase option, this lease would have been classified as a finance lease in the absence of the requirement to retain lease classification in a business combination. However, because the lease is not modified as a result of the acquisition, it retains its operating lease designation.

When it is reasonably certain that a purchase option will be exercised, a lessee will typically classify the lease as a finance lease and would thus amortize the asset in accordance with the framework for subsequent measurement of a finance lease. ASC 842-20-35-8 explains this subsequent measurement:

A lessee shall amortize the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying asset.

However, the concept of amortizing a ROU asset through the end of the useful life of an underlying asset that extends beyond the contractual term is not contemplated for operating leases under ASC 842, since a purchase option that the lessee is reasonably certain to exercise would typically disqualify the lease for operating lease treatment. Thus, questions have arisen regarding whether the ROU asset should be amortized over the remaining contractual term of the lease or over the remaining useful life of the underlying asset when an acquirer in a business combination concludes that it is reasonably certain to exercise a purchase option in an operating lease.

In such circumstances, the ROU asset should be amortized over the remaining useful life of the underlying asset, which is 10 years in the scenario discussed above. While the remaining contractual term of the lease in the above example is only four years, the economic substance of the transaction is the acquisition of an asset with a 10-year useful life because it is reasonably certain that the purchase option will be exercised.

Further, ASC 842-10-30-1 through 30-3 describe what periods are considered to be within the lease term, stating that such periods include the noncancelable period and periods covered by an option to extend the lease when the exercise of such options is reasonably certain. An entity should evaluate purchase options in the same manner in which it considers options to extend or terminate the lease. The FASB explained this in paragraph BC218 of ASU 2016-02, which states:

On reconsideration, in issuing the 2013 Exposure Draft, the Board decided that purchase options should be accounted for in the same way as options to extend the term of a lease (that is, the exercise price of a purchase option would be included in the measurement of lease assets and lease liabilities if the lessee had a significant economic incentive to exercise that option). Topic 842 affirms that decision but, instead, consistent with the Board’s decision about options to extend (or not to terminate) a lease, refers to whether the lessee is reasonably certain to exercise the purchase option on the basis of an evaluation of relevant economic factors. The Board concluded that a purchase option is the ultimate option to extend the lease term. A lessee that has an option to extend a lease for all of the remaining economic life of the underlying asset is, economically, in a similar position to a lessee that has an option to purchase the underlying asset. Accordingly, the Board decided that those two options should be accounted for in the same way. [Emphasis added]

Therefore, a lease that includes a purchase option that is reasonably certain to be exercised is similar to a lease containing optional renewal periods that are reasonably certain to be exercised and that would extend the lease to cover the remaining economic life of the asset. In other words, the economics of a lease with a four-year contractual term and a 10-year useful life of the underlying asset are the same regardless of whether the lessee has an option to purchase the asset at the end of the lease term or an option to extend the lease term for an additional six years. In both instances, the lessee is able to direct the use of and obtain benefit from using the asset for a 10-year period. Accordingly, the entity should amortize the ROU asset over 10 years when it is reasonably certain that it will exercise the purchase option.

We believe that there are two acceptable approaches (described below) for measuring the amortization of the ROU asset over the useful life of the underlying asset when an acquirer in a business combination concludes that it is reasonably certain to exercise a purchase option in an operating lease. The election of either approach is a policy choice that should be consistently applied. Given the complexity of both approaches, entities are encouraged to consult with their accounting advisers in such situations.

8.3.5.1.2.1 Approach 1: Amortize the ROU Asset by Calculating a Single Lease Expense for the Asset’s Entire Useful Life

A “straight-line approach” is one way to measure the amortization of the ROU asset to record in each period. Under such an approach, a single lease expense is calculated and the same total expense (i.e., $35,000 in the example above)5 is recorded in each year of the underlying asset’s 10-year useful life. The amortization of the ROU asset would be lessened by interest expense throughout the contractual term in a manner consistent with the bifurcation of a single lease expense between its interest expense and amortization expense components under an operating lease framework. The remaining ROU asset would be reclassified to PP&E when the purchase option is exercised at the end of year 4. Once the asset is purchased, P should apply the guidance on depreciation in ASC 360-10. Under this approach, the ROU asset at the end of year 4 would have a carrying value of $210,000, which would be depreciated over the remaining six years of the asset’s useful life (or $35,000 per year).

Approach 1 results in greater amortization/depreciation of the asset in the years after the end of the contractual term of the lease. As a result, the carrying value of the asset upon execution of the purchase option may be higher than the purchase option price. While the asset could therefore be recorded at an amount higher than its actual cost (the carrying value of the asset is $210,000 in the above example, while the purchase price is $200,000), we believe that Approach 1 is consistent with the overall straight-line expense approach generally prescribed for operating leases and is acceptable as an application of the single lease cost model throughout the useful life of the asset.

The table below illustrates the straight-line expense approach.

8.3.5.1.2.2 Approach 2: Amortize the ROU Asset by Reference to the Outcome That Would Have Resulted From a Finance Lease

A second approach to measuring the amortization of the ROU asset would be to calculate the amortization in such a way that the ending ROU asset at the end of the contractual lease term (i.e., when the purchase option is exercised) would be the same ending balance as if the lease had been classified as a finance lease (in which case the ROU asset would be amortized on a straight-line basis over the useful life of the underlying asset). Once the purchase option is exercised, the carrying value would then be transferred to PP&E and depreciated in accordance with ASC 360-10. Although this approach results in the same ROU asset balance at the end of the lease term as if the lease were a finance lease, because the lease must be accounted for as an operating lease, P would need to adjust the relative amount of amortization taken during each year of the lease term to maintain an overall straight-line lease expense (including both interest and amortization) over the lease term. As a result of this approach, the entire financing component (i.e., interest) of the asset’s acquisition would be accounted for during the lease term while the single lease cost framework for the acquired operating lease would be preserved but would feature different straight-line expense amounts before and after the purchase of the underlying asset.

Under this approach, P will recognize a single lease expense over the four-year lease term that will result in the ending ROU asset balance of $180,422 at the end of year 4, which is calculated as ($300,703 ÷ 10-year useful life) × 6-year life remaining. This balance would correspond to the ending balance of a ROU asset calculated under the finance lease expense methodology. However, although the average amortization of the ROU asset is $30,070 per year during the lease term, the amortization in each year is adjusted to maintain an overall straight-line lease expense during the lease term. As with Approach 1, the ROU asset would be reclassified to PP&E once the purchase option is exercised at the end of year 4 and would be depreciated over its remaining useful life in accordance with ASC 360-10. Provided that a straight-line depreciation method is selected, P would record depreciation expense of $30,070 each year over the remaining useful life of the asset (consistent with the average annual amortization during the lease term).

This approach results in recognition during the lease term of all of the interest expense, together with a proportional amount of the asset amortization/depreciation, while only the depreciation of the asset is recognized after the lease term. Accordingly, this approach results in a higher cost recorded during the contractual lease term than Approach 1. This second approach is illustrated in the table below.

We believe that the approaches described and illustrated above are acceptable in these circumstances and are in keeping with the straight-line expense recognition guidance applicable to operating leases. ASC 842 does not explicitly acknowledge or address such a scenario; therefore, there may be other acceptable approaches. Companies contemplating an approach other than the two discussed above are encouraged to consult with their auditors or accounting advisers.

8.3.5.1.3 Determining Lease Classification When a Lease Is Acquired in an Asset Acquisition

ASC 842 does not provide guidance on how an entity should determine lease classification when a lease is acquired in an asset acquisition. In the absence of guidance specific to asset acquisitions, we believe that there are two acceptable alternatives: an entity can either (1) retain the previous classification of the seller or (2) reassess the lease classification. Application of more than one alternative in the same asset acquisition transaction would not be expected.

8.3.5.1.3.1 Retain Previous Lease Classification

We believe that it would be acceptable to analogize to the business combination guidance in ASC 842-10-55-11, which requires that the previous lease classification be retained unless there is a lease modification and that modification is not accounted for as a separate contract:

In a business combination or an acquisition by a not-for-profit entity, the acquiring entity should retain the previous lease classification in accordance with this Subtopic unless there is a lease modification and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.

Under this alternative, an entity would not reassess the lease classification when a lease is acquired in an asset acquisition, provided that only the identity of the lessee or lessor, but not any other provisions of the lease, is changed. In these circumstances, an entity views the asset acquisition as a continuation of the historical lease agreement.

ASC 842-20-20 defines a lease modification as a “change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease.” We do not believe that a change only in the parties to a lease is contemplated in this definition, since such a change does not alter scope or consideration.

8.3.5.1.3.2 Reassess Lease Classification

We also believe that it would be acceptable to reassess lease classification by considering each lease acquired as a new lease on the date of the asset acquisition. The fact that the FASB provided specific guidance related to business combinations but did not extend that guidance to asset acquisitions may indicate that the Board did not intend for entities to use the same approach for asset acquisitions. In addition, unlike an acquiring entity in a business combination, an acquiring entity in an asset acquisition may not have the information necessary to determine the original classification of the lease. Under this alternative, an acquiring entity in an asset acquisition would reassess lease classification as of the acquisition date since that date marks the entity’s first involvement with the lease (i.e., it is a new lease from the acquiring entity’s perspective).

8.3.5.2 Related-Party Leases

Before the adoption of ASU 2023-01, ASC 842-10-55-12 indicates that related-party leases (leases between parties under common control) should be classified in the same manner as leases between unrelated parties (i.e., on the basis of the legally enforceable terms and conditions of the lease). Specifically, ASC 842-10-55-12 states:

Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties.

After adopting ASU 2023-01, private companies, as well as not-for-profit entities that are not conduit bond obligors, can elect an optional practical expedient for related-party arrangements between entities under common control. This practical expedient allows for the evaluation of a common-control lease on the basis of the written terms and conditions of such an arrangement.

See Section 13.2 for more information about related-party leases and the next section for further details on leases between parties under common control and the optional practical expedient.

8.3.5.2.1 Leases Between Parties Under Common Control

Parties under common control often enter into intercompany agreements, some of which could meet the definition of a lease under ASC 842 (regardless of whether they are formally documented).

Before the adoption of ASU 2023-01, the guidance in ASC 842 on accounting for related-party leases is limited to that in ASC 842-10-55-12 (see above) and paragraph BC374 of ASU 2016-02, which states:

The Board decided that the recognition and measurement requirements for all leases should be applied by lessees and lessors that are related parties on the basis of legally enforceable terms and conditions of the arrangement, acknowledging that some related party transactions are not documented and/or the terms and conditions are not at arm’s length. In addition, lessees and lessors are required to apply the disclosure requirements for related party transactions in Topic 850. In previous GAAP, entities were required to account for leases with related parties on the basis of the economic substance of the arrangement, which may be difficult when there are no legally enforceable terms and conditions of the arrangement. Examples of difficulties include related party leases that are month to month and related party leases that have payment amounts dependent on cash availability. In these situations, it is difficult and costly for preparers to apply the recognition and measurement requirements. Even when applied, the resulting information often is not useful to users of financial statements.

While this guidance on accounting for related-party leases may appear to be clear — that is, an entity would not impute provisions that do not legally exist or cannot be enforced — questions have arisen regarding whether terms that are outside the lease agreement create legally enforceable terms and conditions that would be considered part of the lease. Such questions, in part, led to the issuance of ASU 2023-01 (see further discussion below).

Unless an entity is eligible for and applies the practical expedient described in ASU 2023-01, the accounting for a lease depends on the enforceable rights and obligations of each party as a result of the contract. This principle applies irrespective of whether such rights or obligations are included in the contract or explicitly or implicitly provided outside of the contract (i.e., there may be enforceable rights or obligations that extend beyond the written lease contract).

While it is clear that the FASB wanted to minimize the cost and complexity of the accounting for leases between parties under common control by limiting the application of the guidance in ASC 842 to rights and obligations that are enforceable (i.e., the parties would not impute any terms or otherwise be required to deviate from the enforceable terms to reflect the substance of the arrangement), we do not think that it would be appropriate to ignore any facts and circumstances related to rights and obligations outside of a lease contract. That is, terms and conditions not written in an agreement or that are included in contracts separate and apart from the lease contract may create enforceable rights and obligations for the parties subject to the lease. For example, while the term of an arrangement may be explicitly limited to six months, factors outside the contract may indicate that the term is longer.

The determination of whether terms and conditions not written in a lease agreement create enforceable rights and obligations to the parties subject to the lease involves judgment and, in some cases, may involve legal questions that should be evaluated with the assistance of legal counsel.

For more information about the practical expedient in ASU 2023-01, see Section 17.3.1.10.

Changing Lanes

Legally Enforceable Terms Versus Arrangement Substance

As part of the FASB’s postimplementation review of ASC 842, private companies asserted that the requirement to assess a common-control lease on the basis of its legally enforceable terms and conditions creates unnecessary cost and complexity for financial statement preparers, since the terms and conditions of such common-control lease arrangements may lack sufficient details, may be uneconomic, or may be changed without approval, given that one party in the common-control group generally controls the arrangement.

In response to such feedback, ASU 2023-01 provides an optional practical expedient under which private companies, as well as not-for-profit entities that are not conduit bond obligors, can use the written terms and conditions of an arrangement between entities under common control to determine (1) whether a lease exists and (2) the subsequent accounting for (and classification of) the lease.

8.3.5.3 Leases Involving Facilities Owned by a Governmental Unit or Authority

ASC 842-10

55-13 Because of special provisions normally present in leases involving terminal space and other airport facilities owned by a governmental unit or authority, the economic life of such facilities for purposes of classifying a lease is essentially indeterminate. Likewise, it may not be practicable to determine the fair value of the underlying asset. If it is impracticable to determine the fair value of the underlying asset and such leases also do not provide for a transfer of ownership or a purchase option that the lessee is reasonably certain to exercise, they should be classified as operating leases. This guidance also applies to leases of other facilities owned by a governmental unit or authority in which the rights of the parties are essentially the same as in a lease of airport facilities. Examples of such leases may be those involving facilities at ports and bus terminals. The guidance in this paragraph is intended to apply to leases only if all of the following conditions are met:

The underlying asset is owned by a governmental unit or authority.
The underlying asset is part of a larger facility, such as an airport, operated by or on behalf of the lessor.
The underlying asset is a permanent structure or a part of a permanent structure, such as a building, that normally could not be moved to a new location.
The lessor, or in some circumstances a higher governmental authority, has the explicit right under the lease agreement or existing statutes or regulations applicable to the underlying asset to terminate the lease at any time during the lease term, such as by closing the facility containing the underlying asset or by taking possession of the facility.
The lease neither transfers ownership of the underlying asset to the lessee nor allows the lessee to purchase or otherwise acquire ownership of the underlying asset.
The underlying asset or equivalent asset in the same service area cannot be purchased or leased from a nongovernmental unit or authority. An equivalent asset in the same service area is an asset that would allow continuation of essentially the same service or activity as afforded by the underlying asset without any appreciable difference in economic results to the lessee.

55-14 Leases of underlying assets not meeting all of the conditions in paragraph 842-10-55-13 are subject to the same criteria for classifying leases under this Subtopic that are applicable to leases not involving government-owned property.

Leases involving terminal space and certain other facilities owned by a governmental unit or authority (e.g., those at airports, bus terminals, and ports) may be subject to special lease classification considerations. For example, as discussed above, it may not be possible to identify the economic life of the underlying asset or practical to determine the fair value of the underlying asset. In such cases, the lease should be accounted for as an operating lease. As described above, the default to operating lease treatment is limited to leases of underlying assets that meet the specific conditions in ASC 842-10-55-13; otherwise, a lessee would apply the lease classification criteria that apply to leases of non-government-owned property.

8.3.5.4 Lessee Indemnification for Environmental Contamination

ASC 842-10

55-15 A provision that requires lessee indemnification for environmental contamination, whether for environmental contamination caused by the lessee during its use of the underlying asset over the lease term or for preexisting environmental contamination, should not affect the classification of the lease.

Contracts that are or contain a lease may include a clause that will indemnify a lessor for any environmental contamination associated with the leased asset, irrespective of whether the contamination resulted from the lessee’s use of the underlying asset over the lease term or from a preexisting condition. This type of indemnification (1) would be considered variable and therefore has no impact on lease classification and (2) would signify that the lessee is retaining certain risks and rewards, which by themselves would not be indicative of control.

Footnotes

Although ASC 842-10-55-3 indicates that an entity need not consider the fourth classification criterion if it is not “practical” to determine the fair value of the underlying asset, we believe that it would be unlikely for a lessee not to be able to determine the fair value of an underlying asset.

See Section 9.2.1.4.2 for a discussion of circumstances in which it would be acceptable for a lessor to take a PRVG into account when assessing the classification of leases in a portfolio.

The measurement of a ROU asset in a business combination incorporates an adjustment for any favorable or unfavorable terms of the lease in comparison to current market terms. For more information about the initial measurement of a ROU asset acquired in a business combination, see Section 4.3.11.1.3 of Deloitte’s Roadmap Business Combinations.

While this section addresses purchase options that an acquirer is reasonably certain to exercise, similar circumstances may arise when renewal options exist that, if exercised, would cause the lease to be classified as a finance lease if it were not for the guidance in ASC 842-10-55-11. Under ASC 805-20-30-24, such extension options constitute part of the acquirer’s “new” lease term if the exercise of such options is reasonably certain as of the acquisition date. Accordingly, both elements of the single lease expense (interest and amortization of the ROU asset) would be recognized over the extended term. With respect to straight-line expense recognition over that term, the lessee should apply one of the approaches described in Example 8-13.

Calculated on the basis of the sum of the total fixed payments of $200,000 (annual fixed payments of $50,000 × 4-year lease term) and the purchase option of $150,000, divided by the 10-year useful life of the underlying asset.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.