Although I have been discussing about lease quiet often, I still receive questions [in various terms] about lease. Through this “lease” post series, I provide answer from the basic [definition and classification of lease], its recognition [Lease in the Financial Statement of Lessee and Lease in the Financial Statement of Lessor] with its disclosures. They are adapted from IAS 17. In this individual post I provide description [with case example as always] specifically just about definition and classification of lease. Enjoy!
IAS 17 provides the following key term and definition about lease:
- Lease; is an agreement whereby the lessor conveys to the lessee in return for payment the right to use an asset for an agreed period of time.
- Finance lease; is a lease that transfers substantially all the risks and rewards of ownership of an asset. Title need not necessarily be eventually transferred.
- Operating lease; is a lease that is not a finance lease.
- Minimum lease payments; are the payments over the lease term that are required to be made. For a lessee, this includes any amounts guaranteed to be paid; for a lessor, this includes any residual value guaranteed to the lessor.
The definition of a lease includes those contracts for hire of an asset that contain provisions for the hirer to acquire title to the asset upon fulfillment of agreed conditions—these are sometimes called hire purchase contracts.
Classification Of Lease
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 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 these descriptions that a large degree of judgment has to be exercised in classifying leases; many lease agreements are likely to demonstrate only a few of the situations listed, some of which are more persuasive than 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 arrangement 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“.
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. If the lease terms are subsequently altered to such a degree that the lease would have had a different classification at it inception, a new lease is deemed to have been entered into. Changes in estimates such as the residual value of an asset are not deemed to be a change in classification.
Leases of land, if title is not transferred, are classified as operating leases, as land has an indefinite economic life and a significant reward of land ownership is its outright ownership and title to its realizable value. If the title to the land is not expected to pass to the lessee, then the risks and rewards of ownership have not substantially passed, and an operating lease is created for the land. Leases of land and buildings need to be treated separately, as often the land lease is an operating lease and the building lease, a finance lease.
Difficulties arise because the minimum lease payments need to be allocated between the land and the building element in proportion to their relative fair values of the leasehold interests at the beginning of the lease. If the allocation cannot be made reliably, then both leases are treated as finance leases or as operating leases, depending on which classification the arrangement more clearly follows.
An entity enters into a lease agreement on July 1, 20X8, that lasts for seven years. The asset’s economic life is 7.5 years. The fair value of the asset is $5 million, and lease payments of $450,000 are payable every six months commencing January 1, 20X9. The present value of the minimum lease payments is $4.6 million. The lease payments were originally due to commence on July 1, 20X8, but the lessor has agreed to postpone the first payment until January 1, 20X9. The asset was received by the entity on July 1, 20X6.
The question is; How the lease agreement should be treated for the year ended January 31, 20X9?
The lease liability should be recognized when the asset is received by the entity and the lease agreement commences, which is July 1, 20X8. The lease is a finance lease because it is for substantially all the asset’s economic life and the present value of the minimum lease payments is substantially all (92%) of the fair value of the asset. During the six-month period before the commencement of the lease payments, interest will be accrued on the lease liability using the interest rate implicit in the lease. In the period to January 31, 20X9, seven months of interest will be accrued. The cash payment on January 1, 20X9, will be apportioned as to the repayment of the lease liability and payment of accrued interest. The asset will be depreciated over the lease term (7 years) in accordance with the depreciation policy for “owned” assets. Read also: Lease in the Financial Statement of Lessee.