1 What is Lease?
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.
The definition of a lease includes contracts for the hire of an asset that contain a provision giving the hirer an option to acquire title to the asset upon the fulfilment of agreed conditions. These contracts are sometimes known as hire purchase contracts.
1.1 Types of leases
There are two types of lease agreements mentioned under IAS 17:
- Finance lease
- Operating lease
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred.
An operating lease is a lease other than a finance lease.
2 Classification of leases
The type of leasing agreement an entity has entered into is identified on the basis of the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee.
Risks include the possibilities of losses from:
- idle capacity
- technological obsolescence
- variations in return because of changing economic conditions
Rewards may be represented by:
- the expectation of profitable operation over the asset’s economic life
- gain from appreciation in value
- realisation of a residual value.
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership.
A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.
2.1 Additional guidance on classification
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.
When the classification of lease is done?
The determination whether risks and rewards has been transferred or not should be done at the inception of lease.
2.2 Changes in provision of lease agreement AFTER classification
If at any time the lessee and the lessor agree to change the provisions of the lease, other than by renewing the lease, in a manner that would have resulted in a different classification of the lease under the criteria in paragraphs 7–12 if the changed terms had been in effect at the inception of the lease, the revised agreement is regarded as a new agreement over its term (which may require a different accounting treatment as opposed to accounting treatment before such changes in provisions)
However, changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased property), or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes.