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Lease classification

control of an asset to a customer, but that fact is not determinative in isolation. A question arises as to
whether an arrangement should first be evaluated under ASC 606 or ASC 842. For example, since
transfer of title does not automatically govern whether an entity has transferred control of an asset to a
customer, it is not clear which standard should govern the accounting when title is not transferred to
the customer at the beginning of the arrangement. Similarly, it is unclear which standard should
govern when an arrangement does transfer legal title to the customer, but that transfer is not, in
isolation, determinative as to whether a sale has occurred.

We believe that reporting entities should generally apply ASC 842, except when legal title transfers at
the beginning of an arrangement. This may result in an entity classifying a lease as a sales-type
(finance) lease, but, nevertheless, the transaction would be accounted for under ASC 842. Reporting
entities should apply the guidance in ASC 606 when legal title is transferred to the customer at the
beginning of an arrangement.

3.3.2 Option to purchase the underlying asset is reasonably certain of exercise

If a lease contains an option to purchase the underlying asset and the option is reasonably certain to be
exercised by the lessee, the lessee and lessor should classify the lease as a finance lease and a sales-
type lease, respectively. An option may be reasonably certain to be exercised by the lessee when a
significant economic incentive exists. For example, this may exist when the price of the option is
favorable relative to the expected fair value of the underlying asset at the date the option becomes
exercisable or when certain economic penalties exist that compel the lessee to elect to exercise its
option. See LG 3.4 for additional information on the impact of economic factors on the application of
the reasonably certain threshold.

3.3.2.1 Purchase option prices

A purchase option, whether fixed price or formula driven, should be evaluated to determine if it
represents a significant economic incentive such that the lessee is reasonably certain to exercise it.
Generally, an option to purchase a leased asset at a price greater than or equal to an asset’s fair value
at lease commencement would not give rise to a significant economic incentive based on price.
Additional consideration is required when a fixed-price option allows the lessee to buy the asset at a
price that is less than the fair value of the asset at the lease commencement date. Both the lessee and
lessor should consider all relevant factors, including the nature of the leased asset and the length of
time before the option becomes exercisable, which may impact the likelihood that the lessee would
exercise the option. For example, an option to purchase real estate at a price below the commencement
date fair value is more likely to be considered reasonably certain of exercise than a similar option on
equipment since real estate is generally expected to appreciate in value over the lease term whereas
equipment is more likely to depreciate in value.

See LG 3.4 for additional information on the application of the reasonably certain threshold.

3.3.3 Lease term is for the major part of the remaining economic life of the asset

If the lease term is for a major part of the remaining economic life of the underlying asset, the lessee
has effectively obtained control of the underlying asset and should classify the lease as a finance lease;
the lessor should classify the lease as a sales-type lease. While ASC 842 does not require the use of
bright lines, one approach to applying this indicator is to consider a lease term to be for a major part if
it is equal to or greater than 75% of the underlying asset’s remaining economic life.

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