A lease that transfers substantially all the risks and rewards incidental to ownership of the asset to the lessee. Title may or may not be transferred.
The standard provides that the substance of the agreement is to be understood. Legal form is not essential for determining whether a lease is an operating lease or finance lease.
IAS 17 mentions several indicators where a lease normally would be considered as finance lease.
Indicator 1: The lease transfers ownership of the asset to the lessee by the end of lease term
AV Ltd leases an asset to T Ltd. The lease term is 10 years. At the end of 10 years, T Ltd would take the asset from AV Ltd. The ownership, as specified under the agreement, will transfer from AV Ltd to T Ltd. This means that the risks and rewards incidental to ownership of the asset would belong to T Ltd. This is an example of finance lease.
Indicator 2: 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 date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised
AV Ltd leases an asset to T Ltd. The lease term is 10 years. As per the lease agreement, T Ltd has an option to buy the asset for $500. The value of the asset is expected to be close to $100,000 at the end of lease term. It is reasonably certain at the time of agreement that T Ltd is going to exercise the option to buy the asset.
This again transfers substantially the risks and rewards incidental to ownership to the lessee. Hence, this would be an example of a finance lease.
Indicator 3: The lease term is for the major part of the economic life of the asset even if title is not transferred.
AV Ltd leases a car to T Ltd for a lease term of 10 years. The useful life of the car is 12 years. Since a significant part of the useful life of the car is used by the lessee, substantially the risks and rewards incidental to the ownership of the car are assumed to be automatically transferred to the lessee. This would be considered as a finance lease. The fact remains that the building has not been sold by the lessor.
Indicator 4: 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.
AV Ltd leases a building to T Ltd for a period of 50 years. The lease rentals are $50,000 per annum. Present value of these lease rentals come to $495,750 considering a discount rate of 10%. The fair value of the machine is $496,000.
In the above case, the underlying assumption is that T Ltd has bought the building and is making the payment on the basis of instalment. It is as good as acquiring a loan amounting to the fair value of the asset (building) and making the payment to the lessor.
The risks and rewards incidental to the ownership are assumed to have been transferred to the lessee, and the lease would be a finance lease.
Indicator 5: The leased assets are of such a specialised nature that only the lessee can use them without major modifications.
AV Ltd is in aviation industry. It owns and also has on lease few aircrafts. Further, AV Ltd has taken on lease several buses to ferry passengers to and from the aircraft to the airport. These buses have been customised by the manufacturer to meet the requirements of AV Ltd. The colour, design of seats, paint, etc are all customised to symbolize AV Ltd’s airlines.
These buses cannot be used for any other purpose or by any other airlines unless major changes are done to these buses. In a manner, the airlines company would be assumed to have taken these buses under finance lease, since the risks and rewards associated with the ownership pertain to the lessee.
Indicator 6: If the lessee can cancel the lease, the lessor’s losses associated with cancellation are borne by the lessee
AV Ltd has taken an office premises on lease for 10 years. After 3 years, AV Ltd wants to cancel the lease since the region in which he operates is not generating enough revenue for him. It approaches G Ltd, the lessor and requests for cancellation of lease agreement.
G Ltd agrees upon a condition that any losses (due to the office remaining idle, or diminution in the value of the office premises
Indicator 7: 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 equaling most of the sales proceeds at the end of the lease);
Indicator 8: the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent