Lease Classification Criteria – Determining Finance and Operating Leases

Lease classification significantly affects financial reporting, determining whether a lease is accounted for as a finance lease or an operating lease. Both U.S. GAAP (ASC 842) and IFRS (IFRS 16) provide specific criteria for lease classification.

This article explains the criteria for lease classification under GAAP and IFRS, highlighting practical examples and differences between the two accounting frameworks.

1. Importance of Lease Classification

Classification impacts:

✦ Recognition and measurement on the balance sheet

✦ Timing and presentation of lease expense

✦ Cash flow presentation (operating vs. financing activities)

Correct classification ensures accurate reporting of financial position and performance.

2. Lease Classification Criteria under U.S. GAAP (ASC 842)

ASC 842 classifies leases into:

✦ Finance leases – Similar to asset purchase

✦ Operating leases – Rental arrangement

If any one of the following five criteria is met, the lease is classified as a finance lease for the lessee:

Criterion 1: Ownership Transfer

Ownership transfers to the lessee by the end of the lease term.

Criterion 2: Purchase Option

Lease contains a bargain purchase option, and the lessee is reasonably certain to exercise it.

Criterion 3: Lease Term

Lease term is for a major part (typically ≥75%) of the asset’s useful life.

Criterion 4: Present Value

Present value of lease payments equals or exceeds substantially all (≥90%) of the asset’s fair value.

Criterion 5: Specialized Asset

Asset is specialized with no alternative use to lessor at lease end.

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

3. Lease Classification under IFRS 16

Under IFRS 16, lessees do not distinguish between operating and finance leases—all leases are capitalized as right-of-use (ROU) assets with corresponding lease liabilities.

However, IFRS retains the distinction for lessors. A lease is a finance lease if it transfers substantially all risks and rewards of ownership to the lessee, otherwise, it's an operating lease.

IFRS criteria include (but are not limited to):

✦ Transfer of ownership at lease end

✦ Purchase option (bargain option)

✦ Lease term is for the major part of asset’s economic life

✦ Present value of lease payments approximates fair value of leased asset

✦ Specialized asset tailored for lessee’s use

4. Practical Example of Lease Classification

Example:

✦ Asset fair value: $100,000

✦ Lease term: 8 years

✦ Asset economic life: 10 years (80% of useful life)

✦ Lease payments (PV): $92,000 (92% of asset fair value)

Analysis under GAAP:

✦ Meets criteria 3 (lease term ≥75% life) and 4 (PV ≥90% fair value)

✦ Classified as a finance lease

Journal entry: Dr. ROU Asset – $92,000 / Cr. Lease Liability – $92,000.

Analysis under IFRS (lessor only):

✦ Transfer of risks/rewards substantial; classified as a finance lease for lessor

✦ Lessee automatically capitalizes under IFRS 16

5. Disclosure Requirements

Entities must disclose:

✦ Lease classification criteria applied

✦ Judgments used in determining classification (discount rates, useful lives)

✦ Details of finance vs. operating leases (for lessors under IFRS)

✦ Nature and terms of significant lease arrangements

Disclosure example: "Leases with terms longer than 75% of the economic life of the assets or present value exceeding 90% of the fair value are accounted for as finance leases."