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ASC 842 Lease Classification
The two main types of leases are operating leases and finance leases. The classification of a lease depends on several criteria.
In this guide, we will discuss the criteria used to classify leases and the accounting treatment for each type of lease. Lease classification is one of the most important aspects of ASC 842 compliance. For a complete understanding of how classification fits into the broader standard, explore our comprehensive ASC 842 guide.
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Operating Leases
Operating leases are leases where the lessee does not assume ownership of the leased asset. The lease term is less than the useful life of the asset.
The lessor retains ownership of the asset and is responsible for maintenance and repairs. Operating leases are typically used for short-term or low-value assets such as office equipment or vehicles.
The criteria used to classify a lease as an operating lease are as follows:
- The lease term is not a major part of the asset's remaining economic life — 75% is the benchmark most companies carry over from ASC 840, but it is a benchmark, not a threshold in the standard
- The present value of the lease payments is not substantially all of the asset's fair value — 90% is the equivalent commonly used benchmark
- The lease agreement does not contain a transfer of ownership clause
That wording matters. ASC 840 set 75% and 90% as bright lines; ASC 842 deliberately replaced them with the qualitative tests above, so a lease at 74% is not automatically an operating lease and one at 76% is not automatically a finance lease. Most companies still use the old percentages as a starting benchmark and document why they are reasonable — which is the part an auditor asks to see.
Accounting Treatment: Operating leases are treated differently than finance leases under ASC 842. The lease payments are recognized as expenses on the income statement.
Under ASC 842, the lease asset and liability are recorded on the balance sheet at the present value of the lease payments. The lease liability is amortized over the lease term.
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Finance Leases
Finance leases are leases where the lessee assumes ownership of the leased asset at the end of the lease term. The lease term is usually longer than the useful life of the asset.
Finance leases are typically used for high-value assets such as machinery or buildings.
The criteria used to classify a lease as a finance lease are as follows:
- The lease term is longer than 75% of the asset's useful life
- The present value of the lease payments is greater than 90% of the fair value of the leased asset
- The lease agreement contains a transfer of ownership clause
Accounting Treatment: Finance leases are recorded differently than operating leases. The lease asset and liability are recorded on the balance sheet at the present value of the lease payments.
The lease liability is then amortized over the lease term. The lease asset is depreciated over the useful life of the asset.
The Five Classification Criteria
Once a contract is a lease, ASC 842-10-25-2 decides whether it is a finance lease or an operating lease. It is a finance lease if any one of five criteria is met — they are not a scorecard, and one is enough.
| Criterion | What it asks | Common benchmark |
|---|---|---|
| Transfer of ownership | Does the lease transfer ownership of the asset to the lessee by the end of the term? | Met or not |
| Purchase option | Is there a purchase option the lessee is reasonably certain to exercise? | Met or not |
| Lease term | Is the lease term a major part of the asset's remaining economic life? | ≥ 75%, by convention |
| Present value | Does the present value of the payments amount to substantially all of the asset's fair value? | ≥ 90%, by convention |
| Specialized asset | Is the asset so specialized it has no alternative use to the lessor at the end of the term? | Judgement |
Fail all five and the lease is an operating lease. The first two are binary and rarely argued. The middle two are where the benchmarks come in, and where the reasoning has to be written down. The fifth is a judgement about the lessor's position rather than yours, and is the one most often overlooked on custom equipment and tenant fit-outs.
The term you test against is the ASC 842 lease term, which includes renewal options reasonably certain of exercise — so an option you fully intend to take can move a lease across the line on its own. Worked entries for each outcome are in operating versus finance lease journal entries, and the wider taxonomy is on types of leases under ASC 842.
Why Classification Drives the Accounting
Lease classification is an important aspect of lease accounting that determines how leases are accounted for in financial statements. The classification of a lease as an operating lease or finance lease depends on several criteria.
These criteria include the lease term, present value of the lease payments, and transfer of ownership clause. By understanding the criteria for lease classification, businesses can ensure accurate financial reporting and compliance with ASC 842 lease accounting standards.
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At iLeasePro, we've been helping companies understand and implement ASC 842 since it replaced ASC 840 for private companies in 2021. We know the standard inside out, and we know how to implement software solutions that will help you be in compliance.
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To do this, call us at 888-351-4606, or you can email us at info@ileasepro.com. We also have plenty of great information about lease accounting software on our website at iLeasePro, and you can chat with a live representative there as well.
Classification is one judgement among several that have to stay right as a portfolio changes. For the rest — remeasurement triggers, modification accounting, the discount rate, and keeping the abstracted data trustworthy — see all 18 ASC 842 compliance articles, grouped by what you are trying to do.