FINANCE LEASE OR OPERATING LEASE?

Under IAS 17 Leases, the classification of a lease as either a finance lease or an operating lease is based on the extent to which the risks and rewards of ownership of the leased asset are transferred to the lessee or remain with the lessor.

 

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.

Situations that, individually or in combination, would usually lead to a lease being a finance lease include the following:

1. Ownership is transferred to the lessee at the end of the lease.
2. The lessee has the option to purchase the asset for less than its expected fair value at the date the option becomes exercisable.
3. The lease term is for a major part of the economic life of the asset, even if the title to the asset is not transferred.
4. At the inception of the lease, the present value of the minimum lease payments is equal to substantially all of the fair value of the asset.
5. The assets are of a specialised nature so that only the lessee can use them without major modifications being made.
6. The lessee will compensate the lessor if the lease is cancelled.
7. Gains or losses from changes in the fair value of the asset fall to the lessee (for example, by means of a rebate of lease payments).
8. The lessee has the option to continue the lease for a secondary period at a rent that is substantially lower than market rent.

In most cases, it will be fairly easy to identify the above situations. The exception is the fourth item. The present value of the minimum lease payments normally has to be calculated using an appropriate discount rate.

Minimum lease payments are the payments over the lease term that the lessee is required to make to the lessor (excluding contingent rent, costs for services and taxes).

IAS 17 does not define 'substantially all', but in practice this is often taken to mean 'more than 90%'.

Illustration 1

Entity A can buy an machinery for cash at a cost of $12,000 or it can lease the asset on the following terms:                                      

(i)  The lease term is for five years from 1 January 20X4, with a rental of $3,000 per annum payable

     on the 31 December each year; and                 

(ii) The interest rate implicit in the lease is 10%.

Required:
Determine whether the lease is a finance lease or operating lease.

Solution

The present value of the minimum lease payments is determined as follows:

Year ended	Cash flow	Discount factor	Present value
		@ 10%
	$		$
31 December 20X4	3,000	1/1.10	2,727
31 December 20X5	3,000	1/1.101	2,479
31 December 20X6	3,000	1/1.102	2,254
31 December 20X7	3,000	1/1.103	2,049
31 December 20X8	3,000	1/1.104	1,863
			11,372

The fair value of the asset is $12,000.

The present value of the minimum lease payments is 95% ($11,372/$12,000) of the fair value of the asset. Therefore, the lease should be classified as a finance lease.

Inception of lease

Classifications of leases are to be made at the inception of the lease. The inception of a lease is the earlier of the agreement date and the date of the commitment by the parties to the principal provisions of the lease.

For example, Entity A leases a machinery from Entity B under finance lease. The lease agreement was dated and signed on 1 March 20X9. However, Entity A made the first lease payment to Entity B on 1 January 20X9, the day on which the machinery was provided to Entity A for use. Therefore, the inception of the lease would be on 1 January 20X9 since on this date, both parties have committed to the principal provisions of the lease.

Leases of land and buildings
Land and buildings are often leased together, but IAS 17 requires the land and buildings elements to be classified separately.

• The land element is normally classified as an operating lease unless the title passes to the lessee at the end of the lease term (because land is considered to have an indefinite life).
• The buildings element may be classified as either a finance lease or an operating lease depending upon the nature of the lease contract.
• The minimum lease payments are allocated between the land and buildings elements in proportion to their relative fair values.

Illustration 2

Vinyson has entered into a lease of property whereby the title to the land does not pass to the entity at the end of the lease but the title to the building passes after 15 years. Under the terms of the lease, Vinyson is required to compensate the lessor if the lease is cancelled before the lease term is fulfilled. However, Vinyson has the option to continue to lease the property for a further 10 years at below market rate lease rentals. Annual lease payments amounted to $5,000 and the fair values of the land and building on the inception of the lease were $1.5 million and $2.5 million respectively.

Required:

(a)  Determine whether the property lease is a finance lease or operating lease.

(b)  What is the amount of annual lease payments attributable to the lease of land and building?

Solution 

(a) The lease of the land is an operating lease as the title to the land does not pass to Vinyson at
     the end of the lease term. The lease of the building is a finance lease as the title to the building

     passes to Vinyson at the end of the lease term. In addition, Vinyson is required to compensate

     the lessor if the lease is cancelled and has the option to continue the lease for a secondary

     period at lease rentals below market value. Clearly, Vinyson is exposed to the risks and

     rewards in respect of the building.

(b) The annual lease payments of $5,000 will be allocated to the land and building elements in
     proportion to their relative fair values as follows:

	Land lease annual payment	= $1.5m/$4m x $5,000	= $1,875
	Building lease annual payment	= $2.5m/$4m x $5,000	= $3,125