Lease accounting: lease classification: defining finance leases under IFRS
IAS 17 (paragraph 4) uses the same definition as FRS102. This is a very similar definition to SSAP21 (IAS17 and FRS102 classify a lease as a finance lease if it ‘transfers substantially all the risks and rewards incidental to ownership’) but it does not refer to the 90% mentioned in SSAP 21. The definition also notes that title may or may not be transferred.
Paragraph 10 of IAS 17 goes on to say 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.’ It then gives examples of situations which would normally lead to a lease being classified as a finance lease:
- 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 the fair value at the date the option becomes exercisable such 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; and
- the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.
Paragraph 11 goes on to provide indicators of situations that individually or in combination could result in a finance lease. These are:
- if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
- 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
- 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.
As with UK GAAP, any question of whether a lease is, or is not, a finance lease must be referred to your local advisory accountants.
An important difference between UK GAAP and IFRS (and FRS101) is that IAS 17 requires the land and buildings elements of a lease to be considered separately for the purposes of lease classification. Unless title is expected to pass to the lessee at the end of the lease term, leases of land should be treated as operating leases. The lease of the building however might be classified as a finance lease. UK GAAP contains no requirement to consider these elements separately.
SSAP 21, FRS102 Section 20 and IAS 17, and the accompanying Notes are well worth studying in order to get a better understanding of the nature of finance leasing and the accounting mechanics.