Classification of Finance Leases
A lease is normally classified as a finance lease if any of the following conditions apply:
- The asset transfers to the lessee at the end of the lease term
- The lessee has an option to purchase the asset from the lessor at below fair value
- The lease term is for a significant part of the asset’s useful economic life
- The present value of future lease payments amounts to substantially all of the asset’s fair value
- The leased asset is specialised in nature, and may only suit the needs of the lessee without major modification
If any of these circumstances arise, it can normally be said that the lease transfers substantially all the risks and rewards of ownership to the lessee.
Finance Lease Assets/Liabilities
When a lease is recognised as a finance lease the lessee will recognise both an asset and liability in its statement of financial position.
Although the legal form of the lease may not transfer ownership of the asset, the substance of the transaction is that an asset is acquired.
This concept is known as the ‘substance over form‘ concept.
As mentioned, the economic substance of the transaction is that the lessee holds the risks and rewards of owning the asset.
Under IAS 17 – Leases, an asset held under a finance lease should be accounted for by the entity as a non-current asset.
Even if legal title does not pass to the entity, it has use of the asset over most of its useful life, and should be recorded as an item of property, plant and equipment.
In the books of the lessor, the asset will not be recorded as an item of property, plant and equipment, but the asset will be the expected future cash flows from lease payments.
Misclassification of Leases
What’s the big deal anyway?
What could go wrong if we accidentally classify a finance lease as an operating lease?
Let’s look:
- The leased asset will not be recorded as an asset in the lessee’s statement of financial position, even though the substance of the arrangement is that the lessee own is, also
- The liability for future lease payments is not recognised in the statement of financial position.
This will result in an understatement of assets and liabilities, which will affect the entity’s performance ratios such as return on capital employed and gearing.
For investors the entity will appear less risky, which is misleading.
These arrangements are known as ‘off balance sheet financing‘.
A good example of where this went wrong was the Enron case, where liabilities appeared lower than they actually were.
Initial Recognition of Finance Leases
At the commencement of a finance lease, the leased asset should be recognised as a non-current asset at the lower of:
- The fair value of the asset, and
- The present value of minimum lease payments.
The fair value of the asset is the amount the entity would pay in cash to purchase the asset outright.
The present value of minimum lease payments are the minimum payments the lessee has agreed to pay, under the lease agreement.
This can be calculated using discounting.
The discount rate to use is the interest rate implicit in the lease, if it can be calculated, otherwise it’s the lessee’s incremental borrowing rate for the asset.
Initial direct costs of the lease, including any negotiation fees or legal fees are added to the initial cost of the asset recognised.
Once the leased asset is recognised in the financial statements, a corresponding liability must be recognised for the finance lease obligations.
This is the ‘capital amount’ of the lease, which will be paid back to the lessor.
There will also be an interest element, to reflect the financing arrangement taking place, where the lessor is essentially financing the acquisition of the asset by the lessee.
To do this, we
| DR | Non-current asset (cost of asset) | XX | ||
| CR | Liabilities (Finance lease obligations) | XX |