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What criteria does the Capital vs. Operating Test use?

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What criteria does the Capital vs. Operating Test use?

The Capital vs Operating Test is performed based on information input specific fields when a new lease is added to the system.
 
Both Useful Life and Fair Value will need to be filled out for the system to perform the Capital vs Operating Test.

Useful Life

The Useful Life of an asset is an estimate of the number of years it is likely to remain in service. Useful Life can be entered on the Dates tab.
 
If no data is entered, the system will prompt you with a message to either enter a Useful Life, or skip the entry and continue.
 
 
 

Fair Value

Fair Value is a rational and unbiased estimate of the potential market price of a good, service, or asset. Fair Value can be entered on the Financial tab, beneath the Base Rent section.

If no data is entered, the system will prompt you with a message to either enter a Fair Value, or skip the entry and continue.

 

ASC 840

Under ASC 840, if a lease meets any of the following four criteria, then it is a capital lease:
  • There is a title transfer at the end of the lease term
  • The lease agreement includes a bargain purchase option
  • The lease term is greater than or equal to 75% of the useful life of the asset
  • The present value of the sum of the lease payments is greater than or equal to 90% of the fair value of the leased asset

ASC 842

Under ASC 842, there is still a distinction between finance and operating leases, and the classification criteria are substantially similar to the previous lease guidance. While ASC 840 and 842 may use similar terms for lessees and lessors, the classification tests are not identical. Lessees will classify leases as a finance lease if the lease meets any of the following criteria:

  • The lease transfers ownership of the underlying asset to the lessee.
  • There is an option to purchase the underlying asset that the lessee is reasonably certain to exercise. Bargain Purchase Option.
  • The lease term is 75% or greater of the remaining economic life of the underlying asset. This does not apply to leases that commence near the end of the asset’s economic life.
  • The present value of the lease payments and any guaranteed residual value is 90% or greater of the fair value of the underlying asset.
  • The underlying asset is specialized in nature and is so specialized that there is no expected alternative use to the lessor at the end of the lease.

ASC 842 has eliminated ASC 840’s “bright lines” tests, which were the “75% of the economic life” and “90% of the fair value” tests and replaces them with a “major part” of the economic life and “equals or exceeds substantially all of the fair value”. However, LeaseGuru still uses these thresholds. 

Specialized Use - Fifth Finance Vs Operating Test

During lease entry, the system now performs the fifth Finance vs. operating test for specialized use

  • There is a new toggle on the dates tab called “Specialized Use” which will default to “No”
  • This toggle can only be set to yes if the lease start date is after the transition date
  • If it is toggled to “Yes” and the lease is classified as Operating, the system will prompt the user to change lease type or override the test 

Additional Content 

ASC 842 has eliminated ASC 840’s “bright lines” tests, which were the “75% of the economic life” and “90% of the fair value” tests and replaces them with a “major part” of the economic life and “equals or exceeds substantially all of the fair value”.
 
The 75% and 90% thresholds would still be appropriate for "substantially all." Most companies will still use these thresholds under ASC 842.
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