Economic Life Test (75% Test)
The term economic life test refers to one of four capitalization criteria used by lessees to account for a leased property. The economic life test attempts to determine if the length of the agreement essentially transfers the risks and rewards associated with ownership of the property to the lessee. If so, then the agreement should be treated as a capital lease.
Companies oftentimes enter into contractual agreements that include the right to use specific property. Since the terms and conditions of these contracts will vary, the Financial Accounting Standards Board issued FAS No. 13 – Accounting for Leases, which outlines the criteria used to determine if the agreement should be treated as a capital versus operating lease.
Also known as the 75% test, the economic life test attempts to determine if a major part of the leased asset’s economic life is consumed over the term of the agreement. Under GAAP, a 75% threshold is used as a guideline when evaluating a lease agreement for the economic life test. That is to say, the purpose of the test is to determine if 75% of the asset’s economic life is consumed over the course of the agreement.
Using the above guidelines, as well as other relevant information, the lessee and lessor should determine if the risks and rewards associated with ownership have been substantially transferred to the lessee through the agreement. If the agreement fails the economic life test, then the lessee should treat the arrangement as a capital lease.
There are a total of four capitalization criteria used by lessees to determine if the property should be treated as a capital lease. If the agreement fails any of the four tests, then the arrangement should be treated as a capital lease. The other criteria include: a transfer of ownership test, a bargain-purchase option test, and a recovery of investment test.
Company A has entered into a ten year agreement with Company XYZ for payment kiosks that will be placed in Company A’s customer care walk-in centers. Working with operations, Company A’s accounting department has determined the technology used in the kiosks will be outdated when the lease expires and the units will have to be replaced.
Since nearly all of the economic value of the leased asset will be consumed over the term of the contract with Company XYZ, Company A’s accounting department will treat the agreement as a capital lease.
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