The Principles That Would Lead To a Lease Being Classified As a ...

A finance lease transfers substantially all the risks and rewards incidental to ownership. Title may or may not eventually be transferred to the lessee. The standard provides certain examples of situations which would normally lead to a lease being classified as a finance lease. Examples of a lease being classified as a finance lease are:

1. The lease transfers ownership of the asset to the lessee by the end of the lease term. Therefore even if the lease is not for a major part of the economic life, if the lease transfers ownership at the end of the lease term, it would be a finance lease, for example, a one year lease which transfer?s ownership at the end of one year is a finance lease.

2. 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. This is also known as a bargain purchase option, for example if a lease contract for three years of a car provides a bargain purchase option to the lessee to buy the car at the end of the lease at a very low price (lets say Rs 10,000 when its fair value at the end of 3 years is estimated to be Rs 75,000) such that it is clear that at the inception of the lease that any lessee would exercise that option, the lease would be classified as a finance lease.

3. The lease term is for the major part of the economic life of the asset even if title is not transferred. Interpreting this clause would call for a lot of judgement. For example, if the lease is of a car for three years, the lease would be for a major part of the economic life if one assumes the economic life of a car to be three years. The lease would not be for a major part of economic life if one assumes that the economic life of a car is lets say six years.

4. At the inception of the lease the present value (determined using appropriate discount rates, for example, in the case of the lessee, his incremental borrowing-rate for similar type of transaction may be used) of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. Minimum lease payments are those that are receivable over the non cancellable lease period. Minimum lease payments exclude contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, etc. A non-cancellable lease is one that is cancellable only: (a) Upon the occurrence of some remote contingency; or (b) With the permission of the lessor; or (c) If the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or (d) Upon payment by the lessee of an additional amount such that, at inception, continuation of the lease is reasonably certain. Which means if permission of the lessor is required for cancellation then the lease is non cancellable though the agreement may term the lease as cancellable. Also a lease cancellable by mutual consent of the lessor and lessee is a non-cancellable lease. Similarly if the penalty for cancellation is huge, the lease may almost be equivalent to a non-cancellable lease. For example, if a 3 year rental contract is cancellable on payment of the entire 3 year rentals, then it is as good as non-cancellable.

5. The leased asset is of a specialised nature such that only the lessee can use it without major modifications being made. For example, the lease is in respect of a highly specialised pharmaceutical plant which can be used only by the lessee.

Examples which individually or in combination could also lead to a lease being?classified as a finance lease are:

6. If the lessee can cancel the lease, the lessors losses associated with the cancellation are borne by the lessee.

7. Gains or losses from the fluctuation in the fair value of the residual fall to the lessee.

8. The lessee can continue the lease for a secondary period at a rent which is substantially lower than market rent.

The first five criteria are determinative in nature, i.e., if any one is met the conclusion would be that the lease is a finance lease. For example, where ownership of the asset is transferred to the lessee at the end of the lease term the lease is a finance lease. Even if the ownership continues with the lessor at the end of the lease term, the lease would be classified as a finance lease if the lease term was for a major part of the economic life of the asset. For example, a PC which is leased for 5 years, where ownership is not transferred to the lessee at the end of the lease term, would still be a finance lease. The last three criteria?s are suggestive in nature and may lead to classification as a finance lease, but not necessarily so. For example, where gains or loss from the fluctuation of the residual value is borne by the lessee, it may indicate that the lessee in substance is the owner (because he suffers the risks and enjoys the rewards) and therefore the lease is a finance lease.

Sometimes the lessor may undertake the responsibility to repair, maintain, update and insure the leased equipment with a view to sufficiently induce the lessee to enter into the lease transaction. Repairing, maintaining and updating and insuring the lease equipment by the lessor does not on its own retain the risk with the lessor. The lessor does this to secure his interest in the lease. For example, most car lease companies, insure the car themselves rather than depend on the lessee to do so, to protect itself from various liabilities. The insurance premium is either recovered from the lessee or built in the overall pricing of the lease rentals. Similarly, repairing and maintaining the machines by the lessor do not transfer the risk of idle capacity or technological obsolescence from the lessee to the lessor. In many cases repairing and maintaining responsibility is retained by the sellers or the lessors, because the expertise is available with them and besides it is a means to influence and attract sale or lease transactions. Therefore even if the lessor retains certain responsibilities, the lease would still be classified as a finance lease if any one of the determinative criteria?s are fulfilled.

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