The core principle to distinguish or differentiate finance lease agreement from operating lease agreement is that if substantial risks and rewards incidental to the ownership of an asset are transferred under a lease agreement to the lessee (person acquiring the asset for use) from the lessor (the owner of the asset) then it is a finance lease otherwise it is an operating lease.
IAS 17 recognises the fact that certain lease agreement can be so complex that it is not easily determinable whether a lease is a finance or an operating lease. Therefore it provides additional guidance. IAS 17 has mentioned several conditions and any of such conditions and indications either individually or in combination is present in the lease agreement then it is considered as a finance lease which are as follows:
- 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 that is expected to be sufficiently lower than the fair value at the time the option will be exercised and at the inception of the lease it is reasonably certain that option to purchase the asset will be exercised by the lessee;
- 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 is equal to fair value or significantly close to fair value in amount
- the leased assets are of such a specialised nature that only the lessee can use them without major modifications.
- 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);
- the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
However, these indications, conditions and examples must not be considered as a conclusive evidence to determine the type of lease agreement rather the circumstances should be taken as a whole to correctly understand the type of the lease agreement.
The determination whether risks and rewards has been transferred or not should be done at the inception of lease.