FASB Statement No. 13: Classification, Accounting, and Replacement

FASB Statement No. 13, issued in November 1976, was the U.S. GAAP standard that told companies how to account for leases. Its mechanism was a set of four numerical tests: a lease that tripped any one of them was a capital lease and went on the balance sheet; a lease that cleared all four was an operating lease and stayed off. Those rules held for forty years before being folded into ASC Topic 840 in 2009 and replaced by ASC Topic 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. Four tests answered that question, and meeting even one was enough to classify the lease as a capital 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 buyout price low enough that exercise was reasonably assured at inception.
The lease term equaled or exceeded 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 75% and 90% tests carried a caveat that is easy to miss: neither could be applied if the lease began during the last 25% of the asset’s total economic life. For the present value calculation, lessees used their own incremental borrowing rate, unless they could determine the lessor’s implicit rate in the lease and that rate was lower, in which case the lessor’s rate was required. Minimum lease payments included required periodic payments, any guaranteed residual value, and penalties for failure to renew, but executory costs paid by the lessor — insurance, maintenance, property taxes — had to be stripped out before discounting.³

How Lessees Recorded Each Type of Lease

Classification determined everything about how a lease showed up in the financial statements, and the two paths produced very different pictures.

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

An operating lease was treated as a rental. Nothing appeared on the balance sheet. The income statement carried a single rent expense line, typically straight-lined over the term. Future payment obligations lived in the footnotes, so a reader who looked only at the balance sheet would not know the commitment existed.

The gap between those two treatments created strong incentives. Two companies with identical cash obligations could report very different leverage, return on assets, and coverage ratios depending on whether their leases qualified as capital or operating.

How Lessors Classified Their Side

SFAS 13 also governed the lessor. 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 at least one of the four bright-line tests, and it also had to satisfy two additional conditions covering the collectibility of payments and the absence of important uncertainties about future costs the lessor would bear.⁴

A sales-type lease applied when the lessor was a manufacturer or dealer, and it let the lessor recognize a sale and the related profit at inception. A direct financing lease had no manufacturer’s profit; the lessor earned only interest income over the lease term. Leveraged leases brought a third-party lender into the structure, with the lessor funding only a portion of the asset’s cost. Leases that failed the collectibility and uncertainty tests were treated as operating leases, with rental income recognized over time.

Why the Standard Was Replaced

The bright lines turned out to be easy to engineer around. A lease term set at 74% of economic life cleared the 75% test. Payments shaped so the present value hit 89% of fair value ducked the 90% test. Omitting a bargain purchase option and an ownership transfer clause took care of the other two. The result was a lease that read as a rental on paper but functioned as a purchase in every economic sense. Lease structuring of this kind was routine, with commercial terms reverse-engineered from the classification thresholds.

A 2005 SEC report put numbers on the scale of the problem. Reviewing public company filings, the SEC estimated that roughly $1.25 trillion in future cash obligations from operating leases sat off corporate balance sheets, disclosed only in footnotes. The report recommended that the FASB reconsider its lease accounting guidance and noted that the existing rules encouraged clustering of lease terms just below the bright-line thresholds.⁵

Complexity added to the pressure for change. Over its lifetime, SFAS 13 was amended by at least nineteen later statements, six formal FASB interpretations, and roughly a dozen technical bulletins, producing a patchwork that even experienced accountants struggled to apply consistently.²

What Replaced SFAS 13

In 2009, the FASB reorganized all of its standards into a single Accounting Standards Codification, and SFAS 13’s requirements were repackaged as ASC Topic 840. The substance did not change. The four tests and the capital-versus-operating split carried over intact under a new label.

The substantive overhaul came in February 2016, when the FASB issued Accounting Standards Update 2016-02 and created ASC Topic 842. Public companies adopted the new rules 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 appears on the balance sheet. Lessees record a right-of-use asset and a corresponding lease liability whether the lease is classified as a finance lease (the new term for capital lease) or an operating lease. Short-term leases — those with an initial term of twelve months or less and no purchase option the lessee is reasonably certain to exercise — can be kept off the balance sheet by election.

The income statement still distinguishes between the two. A finance lease produces separate depreciation and interest charges, front-loading the total expense in the same pattern capital leases produced under SFAS 13. An operating lease produces a single straight-line expense. The difference from the old rules is that both types now show the asset and liability on the balance sheet.

The IFRS Comparison

The international equivalent of SFAS 13 was IAS 17, which used a similar but less rigidly quantified split between finance and operating leases. When IFRS 16 replaced IAS 17 in 2019, international standard-setters went further than the FASB. IFRS 16 eliminates the dual classification model for lessees entirely. Every on-balance-sheet lease is accounted for as a finance lease, with separate depreciation and interest charges on the income statement. There is no operating lease category for lessees under IFRS.⁶

Because ASC 842 still gives operating leases straight-line expense treatment, a U.S. filer and an IFRS filer with economically identical leases will often report different EBITDA and different expense timing. Comparisons across the two frameworks need to account for that gap.