IAS 17 Leases stipulates that whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract.
Situations that, individually or in combination, would normally lead to a lease being classified as a finance lease are :
- the lease transfers ownership of the asset 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 sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
- the lease term is for the major part of the economic life of the asset even if title is not transferred;
- at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased assets; and
- the leased assets are of such a specialised nature that only the lessee can use them without major modifications.
Of the third criterion, it may stir a question about the threshold of the ‘major part of the economic life of the asset’. IAS 17 was not clearly explained this definition. But, if we refer to the US GAAP of SFAS 13 Accounting for Leases, in paragraph 7c, the standard stated that the lease term is equal to 75 percent or more of the estimated economic life of the leased property. So, if the lease term met the 75% of the estimated economic life of the leased asset, it fulfilled the third criteria and the lease has to be classified as a finance lease.
Besides, a query may also arise from the fourth criterion that defines what are essentially arrangements to fully compensate the lessor for the entire value of the leased property as financing arrangements. Under IAS 17, such quantitative threshold is not provided. While the US GAAP of SFAS 13 in paragraph 7d states that the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him. So, based on the US GAAP, the threshold of the present value of minimum lease payments amounts must be at least 90% of leased asset fair value to be classified as a finance lease (Hrd).
