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Lease classification

3.1 Chapter overview

Prior to the adoption of ASC 842, lease classification determines not only how lease expense is
recorded in the income statement, but also whether a lessee is required to record an asset and a
liability associated with its obligations under the lease. Classification is based on a number of criteria,
including specific bright lines and numerous interpretations. Lessees often prefer operating leases
because recognition of the underlying asset and associated lease liability is not required and rent
expense is recognized on a straight-line basis over the lease term. A capital lease requires the lessee to
reflect an asset and corresponding lease liability equal to the present value of the future lease
payments.

A lessor always reflects lease-related assets on its balance sheet; for operating leases, a lessor records
the asset under lease; for leases classified as either sales-type or direct financing, a lessor derecognizes
the leased asset and records its net investment in the lease (equal to the present value of the lease
payments expected to be received over the lease term and the present value of the unguaranteed
estimated residual value of the asset at the end of the lease term).

Under ASC 842, virtually all leases will require balance sheet recognition as a right-of-use asset and
lease liability. However, lease classification will impact the amount and timing of lease income and
expense.

This chapter discusses the different types of leases, lease classification criteria, and the effect of
various features and terms on lease classification under ASC 842. The accounting for leases is
discussed in LG 4.

3.2 Overview of lease classification

The terms of a lease arrangement determine how a lease is classified and the resulting income
statement recognition. When the terms of a lease effectively transfer control of the underlying asset,
the lease represents an in substance financed purchase (sale) of an asset and the lease is classified as a
finance lease by the lessee and a sales-type lease by the lessor. When a lease does not effectively
transfer control of the underlying asset to the lessee, but the lessor obtains a guarantee for the value of
the asset from a third party, the lessor would classify a lease as a direct financing lease. All other leases
are classified as operating leases. See LG 7 for information on leveraged leases, a specific model
applicable to certain direct financing leases. Leveraged leases are eliminated in the new standard, but
leveraged leases that exist at the adoption date of the new standard are grandfathered.

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