Your document headline

• The present value of the minimum lease payments is equal to substantially all of the fair value of the asset.
• The leased assets are of a specialized nature such that only the lessee can use them without significant modification.
Situations that, individually or in combination, could lead to a lease being a finance lease include
• If the lessee can cancel the lease, and the lessor’s losses associated with cancellation are borne by the lessee.
• Gains or losses from changes in the fair value of the residual value of the asset accrue to the lessee.
• The lessee has the option to continue the lease for a secondary term at substantially below-market rent.
It is evident from these descriptions that a large degree of judgment has to be exercised in classifying leases; many lease agreements are likely to demonstrate only a
few of the situations listed, some of which are more persuasive than others. In all cases, the substance of the transaction needs to be properly analyzed and understood.
Emphasis is placed on the risks that the lessor retains more than the benefits of ownership of the asset. If there is little or no related risk, then the agreement is likely to
be a finance lease. If the lessor suffers the risk associated with a movement in the market price of the asset or the use of the asset, then the lease is usually an operating
lease.
The purpose of the lease arrangement may help the classification. If there is an option to cancel, and the lessee is likely to exercise such an option, then the lease is
likely to be an operating lease.
Classifications of leases are to be made at the inception of the lease. The inception of a lease is the earlier of the agreement date and the date of the commitment by
the parties to the principal provisions of the lease. If the lease terms are subsequently altered to such a degree that the lease would have had a different classification at
its inception, a new lease is deemed to have been entered into. Changes in estimates such as the residual value of an asset are not deemed to be a change in
classification.
IAS 17 was amended to delete guidance stating that a lease of land with an indefinite economic life is normally classified as an operating lease, unless at the end of
the lease term, title is expected to pass to the lessee. Under the amendments, a land lease with a lease term of several decades or longer may be classified as a finance
lease, even if at the end of the lease term title will not pass to the lessee, because in such arrangements substantially all risks and rewards are transferred to the lessee
and the present value of the residual value of the leased asset is considered negligible. Also, when a lease includes both land and buildings elements, an entity should
determine the classification of each element, taking account of the fact that land normally has an indefinite economic life. If as a result of the amendments, a lease is
reclassified as a finance lease, then that reclassification should be effected retrospectively. If, however, information necessary to apply the amendments retrospectively
is not available, then classification is determined based on the facts and circumstances at the adoption date of the amendments. The asset and liability relating to a land
lease are recognized at their respective fair values, with any difference between those values being recognized in retained earnings. In classifying a lease of land and
buildings, land and buildings elements would normally be separate. However, separate measurement of the land and buildings elements is not required if the amounts
for land are immaterial or the lessee’s interest in both land and buildings is classified as an investment property in accordance with IAS 40 and the fair value model is
adopted. If title to the land is likely to pass at the end of the lease, it is likely that both leases will be finance leases.
Difficulties arise because the minimum lease payments need to be allocated between the land and the building element in proportion to their relative fair values of
the leasehold interests at the beginning of the lease. If the allocation cannot be made reliably, then both leases are treated as finance leases or as operating leases,
depending on which classification the arrangement more clearly follows.
PRACTICAL INSIGHT
SWISSCOM AG states in its financial statements that revised IAS 17 requires that the land and buildings elements of a lease of land and buildings should
be considered separately for the classification of leases. The land element is classified normally as an operating lease unless title passes to the lessee at the
end of the lease term. SWISSCOM discloses that it entered into sale and leaseback transactions, some of which are classified as finance leases with no
distinction being made between the land and buildings elements. In accordance with revised IAS 17, those land elements classified as finance leases will be
derecognized. Although there will be an effect on assets and liabilities, SWISSCOM says there will not be any material effect on operating income.
If the lessee is to classify the land and buildings as investment property under IAS 40 and the fair value model is adopted (the required model for operating leases
under IAS 40), then separate measurement is not required. Under IAS 40, property held by a lessee under an operating lease can be classified as investment property
and accounted for as if it were a finance lease.
Facts
CASE STUDY 1
An entity enters into a lease agreement on July 1, 20X8 that lasts for seven years. The asset’s economic life is 7.5 years. The fair value of the asset is $5
million, and lease payments of $450,000 are payable every six months commencing January 1, 20X9. The present value of the minimum lease payments is
$4.6 million. The lease payments were originally due to commence on July 1, 20X8, but the lessor has agreed to postpone the first payment until January
1, 20X9. The asset was received by the entity on July 1, 20X8.
Required
Describe how the lease agreement should be treated for the year ended January 31, 20X9.
Solution
The lease liability should be recognized when the asset is received by the entity and the lease agreement commences, which is July 1, 20X8. The lease is a
finance lease because it is for substantially all of the asset’s economic life and the present value of the minimum lease payments is substantially all (92%) of