Classification of Lease Ind AS 17

14/09/2022 0 By indiafreenotes

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. All other leases are classified as operating leases. Classification is made at the inception of the lease. [IAS 17.4]

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease include the following: [IAS 17.10]

  • 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 which is expected to be sufficiently
  • Lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain 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 asset
  • The lease assets are of a specialised nature such that only the lessee can use them without major modifications being made

Other situations that might also lead to classification as a finance lease are: [IAS 17.11]

  • If the lessee is entitled to cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee.
  • Gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments).
  • The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent

When a lease includes land and buildings elements, an entity assesses the classification of each element as finance or an operating lease separately. In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life [IAS 17.15A]. Whenever necessary in order to classify and account for a lease of land and buildings, the minimum lease payments (including any lump-sum upfront payments) are allocated between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception of the lease. [IAS 17.16] For a lease of land and buildings in which the amount that would initially be recognised for the land element is immaterial, the land and buildings may be treated as a single unit for the purpose of lease classification and classified as a finance or operating lease. [IAS 17.17] However, separate measurement of the land and buildings elements is not required if the lessee’s interest in both land and buildings is classified as an investment property in accordance with IAS 40 and the fair value model is adopted. [IAS 17.18]

Finance lease indicators

There are many risks and rewards outlined within the standard, but for the purpose of the Paper F7 exam there are several important areas. The main reward is where the lessee has the right to use the asset for most of, or all of, its useful economic life. The primary risks are where the lessee pays to insure, maintain and repair the asset.

When the risks and rewards remain with the lessee, the substance is such that even though the lessee is not the legal owner of the asset, the commercial reality is that they have acquired an asset with finance from the leasing company and, therefore, an asset and liability should be recognised.

Other indicators that a lease is a finance lease include:

  • At the inception of the lease the present value of the minimum lease payments amounts to substantially all of the fair value of the asset
  • The lease agreement transfers ownership of the asset to the lessee by the end of the lease
  • The leased asset is of a specialised nature
  • The lessee has the option to purchase the asset at a price expected to be substantially lower than the fair value at the date the option becomes exercisable

Finance lease accounting

Initial accounting

The initial accounting is that the lessee should capitalise the finance leased asset and set up a lease liability for the value of the asset recognised. The accounting for this will be:

Dr Non-current assets

Cr Finance lease liability

(This should be done by using the lower of the fair value of the asset or the present value of the minimum lease payments*.)

*Note: The present value of the minimum lease payments is essentially the lease payments over the life of the lease discounted to present value you will either be given this figure in the Paper F7 exam or, if not, use the fair value of the asset. You will not be expected to calculate the minimum lease payments.

All other leases are classified as operating leases.

  1. Substance over form: Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form.
  2. Indicators to classify finance Lease: Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are:
  • If the lessee is entitled to cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee
  • Gains or losses from fluctuations in the fair value of the residual accrue to the lessee (for example, by means of a rebate of lease payments)
  • The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.