The Right Way to Classify A Lease

Definitions

A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred.

An operating lease is a lease other than a finance lease.

Classification of Leases

The classification of a lease as either a finance lease or an operating lease is critical as significantly different accounting treatments are required for the different types of lease. The classification is based on the extent to which risks and rewards of ownership of the leased asset are transferred to the lessee or remain with the lessor. Risks include technological obsolescence, loss from idle capacity, and variations in return. Rewards include rights to sell the asset and gain from its capital value.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards of ownership to the lessee. If it does not, then it is an operating lease. When classifying a lease, it is important to recognize the substance of the agreement and not just its legal form. The commercial reality is important. Conditions in the lease may indicate that an entity has only a limited exposure to the risks and benefits of the leased asset. However, the substance of the agreement may indicate otherwise. Situations that, individually or in combination, would usually lead to a lease being a finance lease include :

• transfer of ownership to the lessee by the end of the lease term
• the lessee has the option to purchase the asset at a price that is expected to be lower than its fair value such that the option is likely to be exercised
• the lease term is for a major part of the economic life of the asset, even if title to the asset is not transferred
• the present value of the minimum lease payments is equal to the substantially all of the fair value of the asset
• the leased assets are of a specialized nature such that only the lessee can use them without significant modification

Situations that, individually or in combination, could lead to a lease being a finance lease include :

• if the lessee can cancel the lease, and the lessor’s losses associated with cancellation are borne by the lessee
• gains or losses from changes in the fair value of the residual value of the asset accrue to the lessee
• the lessee has the option to continue the lease for a secondary term at substantially below market rent

It is evident from the descriptions that a large degree of judgment has to be exercised in classifying lease; many lease agreements are likely to demonstrate only a few of the situations listed, some of which are more persuasive that others. In all cases, the substance of the transaction needs to be properly analyzed and understood. Emphasis is placed on the risks that the lessor retains more than the benefits of ownership of the asset. If there is little or no related risk, then the agreement is likely to be a finance lease. If the lessor suffers the risk associated with a movement in the market price of the asset or the use of the asset, then the lease is usually an operating lease.

The purpose of the lease agreement may help the classification. If there is an option to cancel, and the lessee is likely to exercise such an option, then the lease is likely to be an operating lease (Hrd).

Source : IFRS Practical Implementation Guide and Workbook (2nd Edition) - Abbas Ali Mirza, Magnus Orrell & Graham J. Holt