BLM11200 - Lease accounting: lease classification: defining finance leases
This manual is being updated to reflect FRS 102 (2024 amendments). For guidance on the tax treatment of accounts prepared under IFRS 16 or the revised FRS 102, please refer to pages within the BLM50000 chapter.
This section is applicable to entities applying FRS 102 pre 2024 amendments or FRS 105, and for lessors only under IFRS 16 and FRS 102 (2024 amendments).
See BLM17000 for lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments).
What is a finance lease?
In legal form a finance lease is just another lease – the legal ownership of the asset lies with the lessor and the lessee only has the right to use the asset.
However, in commercial terms, finance leasing is a method of providing finance. In other words, in economic substance a finance lease is a loan of money with the asset as security. The ‘economic’ ownership of the asset – the risks and rewards of ownership – lies with the lessee. In substance the finance lessee buys the asset with a loan from the finance lessor.
To put it another way, a finance lease may be viewed as an arrangement under which one person (the lessor) provides the money to buy an asset which is used by another (the lessee) in return for an interest charge. The lessor has security because they own the asset. The terms of the leasing arrangements aim to give the lessor an interest-like return and no more or less – however good or bad the asset proves to be for the end user.
The return may be very small (a fraction of a percent) for finance leases of very expensive assets (such as ships and aircraft), but several percentage points for leases of less expensive items (such as machine tools or photocopiers). The generally very small return for larger leases reflects the generally very high credit rating of the lessees.
Accounting definition of a finance lease
FRS 102 (pre 2024 amendments) and FRS 105 Glossary defines a finance lease as ‘a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. A lease that is not a finance lease is an operating lease.’ This definition also applies for lessors only under FRS 102 (2024 amendments) and IFRS 16.
FRS 102 (pre and post 2024 amendments), FRS 105 and IFRS 16 confirm that whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract.
The standards go on to give examples of situations that, individually or in combination, would normally lead to a lease being classified as a finance lease: (FRS 102 (pre 2024 amendments) 20.5, FRS 102 (2024 amendments) 20.88, FRS 105.15.6, IFRS 16.63):
(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
(d) 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; and
(e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.
Further, all standards go on to provide indicators of situations that individually or in combination could result in a finance lease. These are: (FRS 102 (pre 2024 amendments) 20.6, FRS 102 (2024 amendments) 20.89, FRS 105.15.7, IFRS 16.64):
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee (eg in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.”
The standards emphasise that these examples and indicators are not always conclusive.
Any question of whether a lease is, or is not, a finance lease should be referred to an Advisory Accountant.