Do you have an operating or financing lease?

How to know what type of lease you have for ASC 842 purposes.

November 12, 2024

Do you have a financing lease or an operating lease? Here’s a simplified breakdown of each test criterion:

1. Reasonably Certain to Exercise Options:

   • If the lessee is reasonably certain they will exercise certain options in the lease (e.g., to purchase or renew), this points toward a financing lease classification.

2. Transfer of Ownership:

   • If ownership of the asset transfers to the lessee at the end of the lease term, the lease is classified as financing because the lessee effectively owns the asset.

3. 90% Fair Market Value Test:

   • If the present value of the lease payments covers at least 90% of the asset’s fair market value, it’s considered a financing lease. For instance, if the lease payments cover 90% or more of the asset’s value, it indicates a transfer of economic benefits, suggesting financing treatment.

4. Useful Life Test:

   • If the lease term covers at least 75% of the asset’s useful life, the lease is classified as financing. For example, if an asset has a useful life of five years and the lease term is four years (80%), this would be classified as financing.

5. Specialized Nature:

   • If the asset is so specialized that it has no alternative use for the lessor after the lease term ends, it’s classified as a financing lease. This criterion indicates that the asset was essentially financed for the lessee, as it’s tailored specifically for their use.

If none of these criteria are met, the lease is classified as an operating lease.

Operating Leases

• Most Common Type: For businesses, particularly those leasing commercial properties, operating leases are common. These leases allow tenants to use an asset (e.g., a building or equipment) without ownership or significant financial obligations associated with asset ownership.
• Criteria: An operating lease is used when the lease doesn’t transfer the risks and rewards of ownership to the lessee. This means there’s typically no option or intent for the lessee to purchase the asset, and the lease term is shorter than the asset's useful life.
• Accounting Impact: Under ASC 842, companies must now recognize operating leases on their balance sheets, showing a right-of-use asset and a lease liability. However, expenses are recorded as lease expenses, not as interest and depreciation (as they would be in a finance lease).

Finance Leases

• Criteria-Based: A lease is classified as a finance lease when it meets one or more criteria suggesting that the lessee gains significant control or ownership benefits over the asset. These criteria include:
  • The lease transfers ownership of the asset to the lessee at the end.
  • There’s a purchase option the lessee is likely to exercise.
  • The lease term covers a major portion of the asset's useful life.
  • The present value of lease payments accounts for most of the asset's fair value.
  • The asset is specialized, with limited value to anyone else.
• Typical Use Case: Finance leases are less common for commercial space leases, as companies rarely intend to own the property. Instead, finance leases are often applied to assets like manufacturing equipment or vehicles, where ownership or long-term use provides a financial advantage.

Why Operating Leases are Preferred for Commercial Real Estate

For most companies leasing office or retail space, operating leases are preferred because they offer flexibility without the responsibilities of ownership, such as long-term asset management or complex financing. These leases allow businesses to occupy space without committing significant capital, which is advantageous for financial planning and risk management, especially in dynamic industries where location needs may change.