FASB Statement No. 13: Classification Tests, Replacement, and IFRS

FASB Statement of Financial Accounting Standards No. 13, issued in November 1976, was the U.S. GAAP rule that told companies how to account for leases. Its defining feature was a set of four numerical tests that sorted every lease into one of two buckets: a capital lease, recorded on the balance sheet as if the lessee had financed a purchase, or an operating lease, kept off the balance sheet and expensed as rent. Those tests governed lease accounting in the United States for four decades before the FASB replaced the standard with ASC 842 in 2016.¹

The Four Classification Tests

SFAS 13 asked whether a lease transferred enough of the risks and rewards of ownership that the lessee was effectively buying the asset. A lease that met even one of the four tests was a capital lease. A lease that failed all four was an operating lease.²

Ownership of the asset transferred to the lessee by the end of the lease term.
The lease contained a bargain purchase option, meaning a price low enough at inception that the lessee was reasonably assured to exercise it.
The lease term was equal to or greater than 75% of the asset’s estimated economic life.
The present value of the minimum lease payments equaled or exceeded 90% of the asset’s fair value at the start of the lease.

The last two tests carried a caveat that mattered in practice. Neither could be applied if the lease began during the final 25% of the asset’s total economic life. A lease starting when the asset was already ten years into a twelve-year useful life, for example, was outside the reach of the 75% and 90% thresholds regardless of the numbers.²

The 90% test required stripping executory costs — insurance, maintenance, property taxes paid by the lessor — out of the payment stream before running the present-value calculation. Lessees discounted using their own incremental borrowing rate, unless they could determine the lessor’s implicit rate and it was lower, in which case that rate had to be used. In practice, the lessor’s rate was rarely known, so borrowing rates carried most calculations.³

How the Two Classifications Looked in the Financial Statements

Classification determined everything about how a lease appeared to readers of the financials, and the two paths did not resemble each other.

A capital lease was treated as a financed purchase. The lessee put an asset and a matching liability on the balance sheet, both measured at the present value of the minimum lease payments. The income statement then carried two separate expenses: depreciation on the asset and interest on the outstanding liability. Because interest was computed using the effective interest method, total expense was front-loaded, higher in the early years when the liability balance was largest.

An operating lease was treated as a simple rental. Nothing went on the balance sheet. A single line of rent expense, usually straight-lined over the term, was the only impact on the income statement. Future payment obligations were disclosed in the footnotes, so a reader who looked only at the balance sheet had no way of seeing them.

The disparity created powerful incentives. Two companies with identical economic obligations could look very different in their debt-to-equity ratios and return on assets depending on how their leases were structured. The payments owed were the same. The reported picture was not.

Lessor Accounting

SFAS 13 also governed the other side of the transaction. Lessors sorted their leases into four categories: sales-type, direct financing, leveraged, or operating. To qualify as anything other than operating, a lease first had to meet one of the same four bright-line tests, and it also had to satisfy two additional conditions about the collectibility of payments and the absence of important uncertainties over future costs the lessor would bear.⁴

A sales-type lease applied when the lessor was a manufacturer or dealer moving inventory through a lease, and any manufacturer’s profit was recognized at inception. A direct financing lease had no such profit component; the lessor earned interest over the term. A leveraged lease brought in a third-party lender, with the lessor putting up only part of the asset cost. If a lease failed the collectibility or uncertainty conditions, it defaulted to operating treatment and produced rental income over time.

Why the Standard Was Replaced

The bright lines were easy to game. A lease term set at 74% of economic life cleared the 75% test. Payments engineered so the present value came in at 89% of fair value ducked the 90% test. Skipping a bargain purchase option and an ownership transfer clause handled the other two. What resulted was a lease that read as a rental on paper but functioned as a purchase in every economic sense.

This was standard practice, not a fringe abuse. Lease contracts were routinely reverse-engineered from the classification tests, with commercial terms driven by what would keep the arrangement off the balance sheet rather than by what fit the underlying transaction.

The SEC put numbers on the problem in 2005. Analyzing public company filings, it estimated that roughly $1.25 trillion in future cash obligations under operating leases sat off corporate balance sheets, visible only in footnotes. The report recommended that the FASB reconsider its lease guidance and noted that lease terms clustered just below the bright-line thresholds.⁵

The rules also became unmanageable. Over its lifetime, SFAS 13 attracted at least nineteen amending statements, six formal FASB interpretations, and roughly a dozen technical bulletins. Consistent application became difficult even for experienced accountants.²

What Replaced SFAS 13

SFAS 13 was recodified as ASC Topic 840 in 2009, when the FASB rolled all of its standards into the Accounting Standards Codification. The tests and the capital-versus-operating distinction were unchanged; only the citation was new.

The substantive replacement came in February 2016 with Accounting Standards Update 2016-02, which created ASC Topic 842. Public companies adopted it for fiscal years beginning after December 15, 2018. Private companies and other nonpublic entities followed for fiscal years beginning after December 15, 2021.

Under ASC 842, nearly every lease with a term longer than twelve months goes on the balance sheet. Lessees record a right-of-use asset and a corresponding lease liability, regardless of whether the lease is classified as a finance lease (the new name for capital lease) or an operating lease. Short-term leases of twelve months or less, with no purchase option the lessee is reasonably certain to exercise, can be kept off the balance sheet and expensed.

The finance-versus-operating split still exists under ASC 842, but only for the income statement. A finance lease produces separate depreciation and interest, front-loading total expense the way capital leases did. An operating lease produces a single straight-line expense. Both types now show the asset and the liability on the balance sheet, which was the reason for the overhaul.

How IFRS Diverged

The international counterpart to SFAS 13 was IAS 17, which drew a similar but less rigidly quantified line between finance and operating leases. When the IASB replaced IAS 17 with IFRS 16 in 2019, it went further than the FASB did and eliminated the dual model on the lessee side entirely. Under IFRS 16, every on-balance-sheet lease is accounted for as a finance lease, with depreciation and interest shown separately.⁶

Under ASC 842, operating leases still get straight-line expense treatment on the income statement even though they sit on the balance sheet. Economically identical leases will therefore produce different EBITDA and different expense patterns depending on which framework a company reports under, which matters when comparing U.S. and international filings.