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Lease classification

EXAMPLE 3-22

Lease classification – lease payments tied to an index (lessee)

Lessee Corp enters into a lease of equipment with Lessor Corp. The following table summarizes
information about the lease and the leased assets.

Lease term 4 years, no renewal option

Economic life of the equipment 7 years

Purchase option None

Annual lease payments The first annual payment is $1,500.

The annual payment increases each subsequent year by an
amount equal to the prior year rent multiplied by the Prime
Rate. For example, if the Prime Rate is 3%, then the lease
payment would be $1,545 ($1,500 + ($1,500 × 3%)).

Payment date Annually on January 1

Lessee Corp’s incremental 8%
borrowing rate
The rate Lessor Corp charges Lessee Corp in the lease is not
readily determinable by Lessee Corp.

Other □ Title to the asset remains with Lessor Corp upon lease
expiration
□ The fair value of the equipment is $10,000; Lessee Corp
does not guarantee the residual value of the equipment at
the end of the lease term

□ Lessee Corp pays for all maintenance of the equipment
separate from the lease

□ There are no initial direct costs incurred by Lessee Corp
□ Lessor Corp does not provide any incentives

Prime rate at the lease commencement date is 3%. The Prime Rate is expected to increase .25% each
year (i.e., the Prime Rate is expected to be 3.25% at the beginning of year 2).

How should Lessee Corp classify the lease?

Analysis

Lessee Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and
ASC 842-10-25-3.

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