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5 Distinguishing Between Finance and Operating Leases
In Illustration 1 above, it is clear that Option 2 is a financing arrangement and should therefore be classified as a finance lease. However, if P only leased the plant and machinery for one
year, paying a total of CU24,000, it would have use of the asset for only a small proportion of its useful life and is not therefore effectively ‘buying’ the asset. In this scenario the
arrangement would not be a financing transaction but instead a rental transaction, and should therefore be treated as an operating lease. The accounting treatment varies according to
which type of lease the lessee holds.
It is sometimes difficult in practice to distinguish between the two types of lease transaction, since arrangements can be very different and often have characteristics of both financing and
rental. IAS 17 therefore provides detailed guidance to assist an entity in making the correct distinction.
5.1 Risks and rewards
The classification of a lease is based on the extent to which risks and rewards associated with ownership are transferred from the lessor to the lessee. If a lease transfers substantially all
the risks and rewards normally associated with the ownership of an asset it should be classified as a finance lease; otherwise, it should be classified as an operating lease.
[IAS 17.8]
Examples of the key risks and rewards that arise from the ownership of an asset are shown in the following table.
Illustration 3 Risk
Reward
Losses may arise: where the asset stands idle for
some time due to lack of sufficient demand;
from a fall in the value of the asset through technical obsolescence;
and from meeting the costs of
maintaining and repairing the asset.
Gains may arise from: the generation of profits from use
of the asset; use of the asset for substantially
the whole of its useful life; and a potential gain arising on the
future sale of the asset where it increases in value.
5.2 Situations indicating the existence of a finance lease
In addition to the guidance described above, IAS 17 also sets out specific situations that, individually or collectively, would normally lead to a lease being classified as a finance lease.
Such situations include where:
ownership of the asset transfers to the lessee by the end of the lease term such arrangements are sometimes known as a hire purchase;
although ownership of the asset does not automatically pass to the lessee at the end of the agreement, the lessee has an option to purchase the asset. The price at which
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the option is set is such that it is reasonably certain that the option will be exercised. In other words, the price is set significantly below the fair value expected of the asset
at the date the option becomes exercisable this is sometimes referred to as a bargain purchase option;
although ownership of the asset is not transferred at the end of the lease term, the term of the lease is for the majority of the economic life of the asset. At the end of the
lease, therefore, the asset will have virtually no further ability to generate future economic benefits;
the asset is so specialised that only the lessee can use it without major modifications; and
the present value of the minimum lease payments payable by the lessee under the lease is equal to substantially all of the fair value of the asset. Where this is the case,
the lessee has effectively paid for the asset in full and therefore should treat the asset as if it had acquired it through a financing arrangement.
Fair value is the amount “for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction ”. [IAS 17.4]
The economic life of an asset is the total period over which it is expected to be able to generate economic benefits for one or more users. [IAS 17.4]
The minimum lease payments are the minimum amount that is payable by the lessee to the lessor under a lease agreement. This comprises all amounts payable under the contract,
including any amounts guaranteed to the lessor by the lessee or any party related to it. In addition, in the context of a lessee, where there is an option to purchase the asset at the end
of the contract and it is expected to be exercised because it has been set at a ‘bargain price’, then this amount should also form part of the minimum lease payments. [IAS 17.4]
As well as the circumstances described above, IAS 17 provides three additional situations that may lead to classification as a finance lease:
losses associated with any cancellation of the lease are borne by the lessee; fluctuations in the fair value at the end of the lease term fall to the lessee; and
the lessee has the option to extend the lease for a secondary period at a rate that is substantially below market rate this is often known as a ‘peppercorn rent’.
[IAS 17.11] To identify the characteristics of a lease over land and buildings the two elements should be
separated. Land is generally considered to have an indefinite life and therefore an associated lease will normally be classified as an operating lease, unless there are other characteristics,
such as title of the land transferring to the lessee, that suggest otherwise. [IAS 17.14]
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6 The Accounting Treatment by Lessees
6.1 An overview
The following section provides a basic overview of the recognition requirements for the two types of lease.
Finance lease recognition Statement of financial position
Recognise a non-current asset Recognise a liability for the lease obligation i.e. the total payments outstanding
including repayment instalments and finance charges accrued to date Statement of comprehensive income
Recognise a charge for the depreciation of the non-current asset Recognise a finance charge for the year
Operating lease recognition Statement of comprehensive income
Recognise the lease instalment charge for the year. The classification of a lease as finance or operating is made at the inception of the lease and
should only be revisited if changes to the lease conditions are made which, if made at the outset, would have resulted in a different classification.
The ‘inception’ of the lease is the earlier of: [IAS 17.4] the date of the lease agreement; and
the date that a commitment is made by the parties to the principal provisions under the lease agreement.
The inception date is also of particular importance for a finance lease as it is the date at which the values for the asset and liability are determined.
The ‘lease term’ is the non-cancellable period for which the lessee has contracted to lease the asset, plus any extension which is likely to be taken up by the lessee. This period is the useful
life for a finance lease asset’s depreciation charges and the period over which operating lease payments are recognised in profit or loss.
6.2 Finance lease recognition
6.2.1 Initial recognition
A lessee should recognise an asset and liability in its statement of financial position at the commencement of the lease term. The amounts should be recorded at the fair value of the
asset or, if lower, the present value of the minimum lease payments, determined at the inception of the lease. [IAS 17.20]
The present value of the minimum lease payments is calculated by establishing the minimum lease payments due under the lease, as explained above, and discounting them to take
account of the time value of money. [IAS 17.20]
