Temporary differences and investments

Chapter 16 – Leases Page 205 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