Recovery of Investment Test (90% Test)

Definition

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.

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.

If the agreement fails the recovery of investment test, then the lessee should treat the arrangement as a capital lease.  Also known as the 90% test, the recovery of investment test compares the present value of the minimum lease payments to the asset's value at the inception of the agreement.  If the present value of these payments is equal to, or greater than, 90% of the asset's fair market value, then the agreement should be treated as a capital lease.

The minimum lease payment is the lowest possible payments a lessee is obligated to make in connection with an asset over the term of an agreement.  Minimum lease payments include the total of all rents paid, any guaranteed residual value of the leased asset, non-renewal penalties paid by the lessee, as well as a bargain-purchase option (if these clauses exist in the contract).  Executory costs are specifically excluded from this calculation.

When determining the present value of these payments, the lessee should use a discount rate that is equal to its incremental cost of borrowing at the inception of the lease.  For example, the discount rate would be equal to the rate of interest charged on a secured loan with a repayment schedule that is similar to the term of the lease.  However, if the lessee knows the rate used by the lessor when structuring the agreement, that rate should be used if it is lower than the lessee's cost of the secured loan.

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 agreement should be treated as a capital lease.  The other criteria include: a transfer of ownership test, an economic life test, and a bargain-purchase test.

Note:  Since most of the risks and rewards associated with owning an asset occur early in its life, the 90% test does not apply if the agreement occurs during the last 25% of the asset's economic life.

Related Terms

operating lease, capital lease, bargain-purchase option test, transfer of ownership test, economic life test, economic life, economic life test, economic life, executory costs, minimum lease payment, guaranteed residual valueunguaranteed residual value