Lease accounting: lease classification: defining finance leases under UK GAAP
Finance leases are defined in similar way under both UK GAAP and IFRS (see BLM11205).
UK GAAP SSAP21 paragraph 15defines a finance lease in the following terms:
“A finance lease is a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. It should be presumed that such a transfer of risks and rewards occurs if at the inception of the lease the present value of the minimum lease payments including any initial payment, amounts to substantially all (normally 90% or more) of the fair value of the leased asset. The present value should be calculated by using the interest rate implicit in the lease (as defined in paragraph 24). If the fair value of the asset is not determinable, an estimate thereof should be used.”
In general terms, the definition identifies whether or not the lessor has the bulk of the equity interest in the leased asset. In particular, what this is saying is that it should be presumed that a lease is a finance lease where the payments by the lessee are certain (subject to the credit risk) to repay substantially all of the cost of the asset (the ‘loan’) to the lessor plus a commercial rate of interest.
Note that ‘substantially all’ means ‘normally 90% or more’ and the definition is based on risks and rewards. It is particularly important to note that the figure of 90% is only indicative - that is, the presumption in the definition is rebuttable.
Therefore, where a lease meets the conditions in paragraph 15 of SSAP 21, the presumption that it should be classified as a finance lease may in exceptional circumstances be rebutted if it can be clearly demonstrated that the lease in question does not transfer substantially all the risks and rewards of ownership (other than legal title) to the lessee. Correspondingly, the presumption that a lease which fails to meet the conditions in paragraph 15 is not a finance lease may in exceptional circumstances be rebutted, see paragraph 16 of SSAP 21.
For example, exceptionally, the rentals can pay all the fair value of the leased asset and GAAP will still regard the lease as an operating lease if the lease does not transfer substantially all the rewards of ownership to the lessee. Equally, it might be possible for the rentals to pay less than 90% of the fair value of the asset and for the lease to be regarded as a finance lease if the lease does transfer substantially all the rewards of ownership to the lessee.
For those UK GAAP entities adopting FRS102, a finance lease is defined 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”.
It goes on to give examples of situations (that, individually or in combination) would normally lead to a lease being classified as a finance lease (Section 20 paragraph 5):
“(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, FRS102 goes on to provide indicators of situations that individually or in combination could result in a finance lease. These are (Section 20, paragraph 6):
“(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 fair value of the residual accrue to the lessee (for example, 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 Standard emphasises that these examples and indicators are not always conclusive.
Any question of whether a lease is, or is not, a finance lease must be referred to your local advisory accountants.