A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. Title may or may not eventually be transferred. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incident to ownership.
Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than its form. Examples of situations which would normally lead to a lease being classified as a finance lease are:
- 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 asset is of a specialised nature such that only the lessee can use it without major modifications being made.
Other indicators that, individually or in combination, could also lead to a lease being classified as a finance lease 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 fall to the lessee
- The lessee can continue the lease for a secondary period at a rent which is substantially lower than market rent.
Lease classification is made at the inception of the lease. If at any time the lessee and the lessor agree to change the provisions of the lease after inception, other than by renewing the lease, in a manner that would have resulted in a different classification, had the changed terms been in effect at the inception of the lease, the revised agreement is considered as a new agreement over its revised term. Changes in estimates or changes in circumstances, however, do not give rise to a new classification of a lease for accounting purposes.