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Lease classification

3.3.5 Underlying asset is of a specialized nature

A lease of an underlying asset that is of such a specialized nature that it is expected to have no
alternative use to the lessor at the end of the lease term should be classified as a sales-type or direct
financing lease by the lessor. This is because a lessor would be expected to price the lease to ensure it
receives a return of its initial investment plus interest from the lessee. For example, if a lessor invests
in the construction of a gas pipeline that will connect land owned by the lessee to a main pipeline and
the pipeline has no alternative use beyond the lessee’s need to transport gas, the lessor would be
expected to price the lease to ensure a return during the noncancellable term of the lease.

The evaluation of whether an underlying asset is expected to have an alternative use to the lessor at the
end of the lease term should consider any contractual restrictions and practical limitations on the
lessor’s ability to change or redirect the use of the underlying asset, as discussed in ASC 842-10-55-7.

ASC 842-10-55-7

In assessing whether an underlying asset has an alternative use to the lessor at the end of the lease
term in accordance with paragraph 842-10-25-2(e), an entity should consider the effects of contractual
restrictions and practical limitations on a lessor’s ability to readily direct that asset for another use (for
example, selling it or leasing it to an entity other than the lessee). A contractual restriction on a lessor’s
ability to direct an underlying asset for another use must be substantive for the asset not to have an
alternative use to the lessor. A contractual restriction is substantive if it is enforceable. A practical
limitation on a lessor’s ability to direct an underlying asset for another use exists if the lessor would
incur significant economic losses to direct the underlying asset for another use. A significant economic
loss could arise because the lessor either would incur significant costs to rework the asset or would
only be able to sell or re-lease the asset at a significant loss. For example, a lessor may be practically
limited from redirecting assets that either have design specifications that are unique to the lessee or
that are located in remote areas. The possibility of the contract with the customer being terminated is
not a relevant consideration in assessing whether the lessor would be able to readily direct the
underlying asset for another use.

3.4 Application of the “reasonably certain” threshold

Reasonably certain should be considered a high threshold. While there are no bright lines, the FASB
has indicated that the threshold is similar to “reasonably assured” in existing GAAP, which implies a
probability of 75% to 80%. An assessment of whether a lessee is reasonably certain to exercise a
renewal, termination, or purchase option should consider the substance rather than the legal form of
the contract.

An entity should assess whether it is reasonably certain that the lessee will exercise an option by
considering all factors relevant to that assessment, including contract-, asset-, market-, and entity-
based factors. Certain factors, such as economic penalties, may make exercise of a renewal,
termination, or purchase option reasonably certain of exercise. Factors to consider include:

□ Whether the purpose or location of the asset is unique

□ The availability of comparable replacement assets

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