Finance vs. Operating Lease

Finance Lease (Previously Capital Lease) vs. Operating Lease

Is it an operating lease?

ASC 842 will not significantly change the recording of finance leases. However, the tests in determining the lease classification have changed. The first step is, therefore, to identify which of your leases may be finance and which are operating.  Each lease must go through five tests to determine its classification. The five tests are:

  • Will the ownership or title of the asset be transferred to the lessee when the lease term ends?
  • Is the lessee reasonably certain to exercise an option to purchase the underlying asset?
  • Is the lease term a major part of the remaining economic life of the underlying asset?
  • Does the present value of the sum of the lease payments, including any residual value guaranteed by the lessee, exceed substantially all of the fair value of the underlying asset?
  • Does the underlying asset have such a specialized nature that it has no alternative use to the lessor at the end of the lease term?

If a lease does not meet any of the above conditions, it is classified as an operating lease under the new ASC 842 regulations.