Hold on to your hats, because one of my readers claims that paragraph 7 of FASB 13 is a fascinating topic. Note the ‘claims to’ wording. You all know that I really like this stuff, but I am not so certain how many of us there really are that can make that statement with a straight face (or would actually want to, for that matter). Anyway, this post is for you, ‘Fascinated in New Jersey.’
You all know that there are four classification criteria 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 7(a) – (d) of FASB 13. I briefly have discussed paragraphs 7(a) and 7(b) already, so paragraph 7(c) must be next. Whereas, the tests of paragraphs 7(a) and 7(b) are used to determine actual ownership and potential ownership by the lessee, respectively, the form of ownership embodied in 7(c) is effective ownership.
This test states that, if the lease term is equal to or greater than 75% of the asset’s useful life, the lease should be classified as capital, the argument being that, if the lessee uses the equipment for a significant portion of its economic life, the lessee is using up the asset's value, just as if it owns the equipment. As I mentioned, the form of ownership in this case is effective ownership. The lease must be classified as capital because it is an ownership agreement.
Many leasing companies ignore the 7(c) test due to its subjectivity and complexity in obtaining/maintaining data. Captive lessors, however, are more likely to perform this test due to the revenue recognition ramifications to the parent. SOX compliance also has increased auditor attention on this test, so I am seeing more companies focusing on better testing of this criteria.
There are two facets to the 75% test – the economic life of the asset and the lease term. FASB 13 defines the economic life of an asset as the useful life in the hands of multiple users, given normal repairs and maintenance. Please note that the economic life is not the IRS life, nor is it the lessee’s book depreciable life for the asset. The economic life, for purposes of this test, continues as long as someone can reasonably use the equipment.
Take the example of a PC. What is its useful life? Your accountant probably says it is three years, while the IRS says it is five years. Here is a simple test for you. Walk through the office, or check at home and see how many PCs that you can find that are still using Windows 98 or Office 2000. What does that tell you about useful life? What about a midrange computer? I have seen some of these used for 15 years. Just because it doesn’t meet your needs doesn’t mean it doesn’t have useful life at a school or in a different economic market. More to follow.
Shawn, with the sale of lease assets between lessors fairly common these days it might be good to cover the lease classification process for assets/leases purchased by a lessor mid-stream. If you follow a strict interpretation of the 90% rule many deals would become operating leases due to the new lessor only acquiring the remaining lease term.
Take care
Larry
Posted by: Larry Duer | April 6, 2006 10:00 AM | Permalink to Comment