Definition
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.
Explanation
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.
Example
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 Working with operations, Company A's accounting department has determined the technology used in the kiosks will be outdated when the lease expires and the units will have to be replaced.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.
Related Terms
- The financial accounting term operating lease is used to describe one of several lease arrangements that a company can hold. Operating leases are used to acquire assets on a relatively short-term basis. The cost of an operating lease appears as an expense on the income statement.
Moneyzine EditorSeptember 20th, 2023 
The Financial Accounting Standards Board rules allow companies two methods to account for leases. If the agreement meets any of the following conditions, the lease should be treated as a capital lease, also known as a finance lease:Moneyzine EditorJanuary 10th, 2024
The term bargain-purchase option test refers to one of four capitalization criteria used by lessees to account for a leased property. A bargain-purchase option allows the lessee to purchase the leased property at a price that is significantly below its market value on the exercise date.Moneyzine EditorJanuary 8th, 2024- The term transfer of ownership test refers to one of four capitalization criteria used by lessees to account for a leased property. The transfer of ownership test simply states: If legal title of the leased property is automatically transferred to the lessee as part of the contract, then the agreement should be treated as a capital lease.Moneyzine EditorSeptember 21st, 2023
The term economic life is defined as the timespan over which the annual cost of owning and operating an asset is minimized. The economic life of an asset can be a function of factors such as physical wear and tear, as well as technological obsolescence.Moneyzine EditorJanuary 16th, 2024- The term recovery of investment test refers to one of four capitalization criteria used by lessees to account for a leased property. The recovery of investment test compares the present value of the minimum lease payments to the asset’s value at the inception of the lease. If the present value of the minimum payments is greater than 90% of the asset’s value, then the arrangement should be classified as a capital lease.Moneyzine EditorNovember 29th, 2022
The term executory costs refers to the normal expenses associated with owning a leased asset, including insurance, maintenance, and taxes. Executory costs are typically paid by the lessee, and may be included as part of the rental payment or a pass through expense paid directly by the lessee.Moneyzine EditorJanuary 17th, 2024
The term minimum lease payment refers to the lowest possible payments a lessee is obligated to make in connection with an asset over the term of an agreement. Minimum lease payments can include rent, residual value, penalties, as well as a bargain-purchase option.Moneyzine EditorFebruary 8th, 2024- The financial accounting term unguaranteed residual value refers to the worth of a lease property at the end of the agreement's term that is not the responsibility of the lessee. Unguaranteed residual values do not qualify as a financial obligation of the lessee, and do not factor into the calculation of the minimum lease payment.Moneyzine EditorSeptember 21st, 2023
The financial accounting term guaranteed residual value refers to an additional payment made by a lessee in property, cash, or both when a lease terminates. Guaranteed residual values are financial commitments made by the lessee, and factor into the calculation of the minimum lease payment.Moneyzine EditorJanuary 19th, 2024
