Defining long funding leases: miscellaneous definitions: term of a lease: 'reasonably certain': example 5 - operating lease at market rate
A ship costs lessor J Ltd £45m. The ship has an expected useful economic life of 20 years. J Ltd leases the ship to K Ltd for 5 years at the open market rate for a 5-year charter; say £5m a year. After 5 years K Ltd can either
- walk away without being required to pay the lessor anything more, or
- extend the lease term for another 5 years at the market rate applying at that time. There is no further option to extend the lease term.
It is accepted that the lease is properly classified as an operating lease under GAAP.
On the simple facts in this example, K Ltd is not reasonably certain to exercise the option to extend the lease term.
If the lessee was only able to walk away at the 5-year point having made a payment to the lessor the rules at CAA01/S70YF (6) and (7) might apply to treat the lease as other than a short lease, see BLM25145.
Note that open market rates can, by definition, be established with some certainty simply because there is an open market. Therefore if you are told that an open market rate has been used you may need to seek evidence that this is the case. Remember, however, that a lessee is unlikely to pay more than the open market rate unless he gains something by so doing - perhaps the right to lease at a lower than market rate at the end of the initial lease period, or the right to buy the asset at below market value (in which case, see BLM00325 onwards).