BLM11200 - Lease accounting: lease classification: defining finance leases

FRS 102 Glossary defines a finance lease as ‘a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred’.

FRS 102 Section 20.5 confirms that whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. It goes on to give examples of situations (that, individually or in combination) would normally lead to a lease being classified as a finance lease:

(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;

(b) 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;

(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;

(d) 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

(e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

Further, FRS Section 102 20.6 goes on to provide indicators of situations that individually or in combination could result in a finance lease. These are:

(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;

(b) gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee (eg in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and

(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.”

FRS 102 emphasises that these examples and indicators are not always conclusive.

Any question of whether a lease is, or is not, a finance lease must be referred to your local advisory accountant.