Four classification criterion are used to determine whether a lease more closely resembles a purchase agreement (capital lease) or an usage agreement (operating lease). These criteria, some of which are more complex than others, are found in paragraph 7of FASB 13. Let’s look at the first two criteria.
1. If the lease automatically transfers ownership of the property to the lessee by the end of the lease term, it is classified as a capital lease.
This is an easy one, and the most obvious of the capital lease criteria as the language indicating title passage is contractual. If the title automatically passes to the lessee during, or by the end of, the lease, the lessee will own the equipment. The form of ownership in this case is actual ownership. The lease is classified as capital because ownership passes. If the lease does not meet this criterion, it may be an operating lease. In order to validate this premise, the next test must be applied.
2. if the lease contains a bargain purchase option, it is classified as a capital lease.
If the lease contains a purchase option so low that the lessee is likely to exercise it, the lessee will buy the equipment. After all, who can pass up a bargain? The form of ownership in this case is eventual ownership. The lease is classified as capital because it is an ownership agreement. If the lease does not meet this or the previous criterion, the next test must be examined.
This is one isn’t quite as easy to determine as the first criteria? After all, what constitutes a bargain purchase option? In a dollar-out lease, the lessee purchases the equipment for one dollar at the end of the lease term. This is clearly a bargain purchase option. In a fair market value (FMV) lease, the lessee can purchase the equipment at the end of the lease for its fair market value. An FMV option clearly is not a bargain purchase option.
Sometimes, however, what constitutes a bargain option is not as clear. For instance, is an 8% purchase option on a mainframe computer a bargain after five years? What about a 28% purchase option on a 747 after seven years? The answers to these questions (no and yes, respectively) are not as clear cut as a dollar purchase option. In these cases, the accountants must exercise judgment and decide how likely the lessee is to exercise the option. If exercise of the option is highly probable because of its price, it is a bargain. Although reluctant to give a bright line to this test, 50% of OLV often is used as a benchmark.
As you can see, the determinants of ownership are becoming more difficult to assess as we progress through paragraph 7 of FASB 13.
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