Introduction to Leases and Classification under AS 19

Understand Introduction to Leases and Classification

Key rules to remember

Finance lease: general test

Substantially all risks and rewards of ownership transfer to lessee → finance lease; otherwise → operating lease

Classification is by substance and made at inception of the lease.

Situations that would normally lead to a finance lease

(a) Ownership transfers to lessee by end of lease term; (b) lessee has a purchase option at a price sufficiently below fair value, reasonably certain to be exercised; (c) lease term covers a major part of the asset's economic life; (d) PV of MLP at inception amounts to substantially all of the asset's fair value; (e) asset is so specialised that only the lessee can use it without major modification

These situations would normally lead to a finance lease, but no single one is conclusive. Judge the overall substance. AS 19 gives no percentages for 'major part' or 'substantially all'.

Other indicators of a finance lease

Lessee can cancel but bears lessor's losses; gains or losses from changes in residual fair value go to lessee; lessee can renew for a secondary period at a rent much lower than market

These can also lead to a finance lease, even if they are not in the main list.

Minimum lease payments: lessee's view

MLP = Rentals over lease term (excluding contingent rent, service costs, and taxes reimbursed to lessor) + residual value guaranteed by lessee or a party related to him

If a bargain purchase option is reasonably certain, also include the price to exercise it.

Minimum lease payments: lessor's view

MLP = Rentals over lease term (same exclusions) + residual value guaranteed to lessor by lessee, a party related to lessee, or a financially capable independent third party

The lessor's MLP can be higher than the lessee's because third-party guarantees count for the lessor only.

Gross investment in the lease

Gross investment = Lessor's MLP + unguaranteed residual value

Used by the lessor in finance lease accounting.

Interest rate implicit in the lease

PV of (lessor's MLP + unguaranteed residual value) = fair value of the leased asset at inception

The implicit rate is the discount rate at which the aggregate PV of the MLP and the unguaranteed residual value, measured from the lessor's view, equals the fair value of the asset at inception. A lessee who cannot determine the implicit rate uses its incremental borrowing rate. For the classification test, use the MLP of the party whose books you are in. The lessee's test compares the PV of the lessee's MLP with fair value, discounted at the implicit rate or, if that cannot be determined, at the lessee's incremental borrowing rate. The lessor's test compares the PV of the lessor's MLP with fair value, discounted at the implicit rate. Do not apply the lessor's MLP in the lessee's test.

How to solve Introduction to Leases and Classification questions

1. 1Note who is lessor and lessee, and from whose books the question is asked. MLP differs by standpoint.
2. 2Confirm that AS 19 applies. Lease agreements to use lands, and natural resource and licensing arrangements, are outside its scope.
3. 3Find the lease term: the non-cancellable period plus any renewal period reasonably certain to be used.
4. 4List the payments. Remove contingent rent, service or maintenance charges, and taxes reimbursed to lessor. Add the guaranteed residual value as per the correct standpoint, and any bargain purchase price.
5. 5Run the finance lease tests one by one: ownership transfer, bargain option, major part of economic life, PV of MLP versus fair value, and specialised asset.
6. 6If one or more tests are met, the lease would normally be a finance lease. Confirm this against the overall substance: do the risks and rewards of ownership move to the lessee? If they do not, or no test is met, it is an operating lease.
7. 7State the conclusion with the reason, and name the next treatment: capitalise asset and liability for a finance lease, or charge rentals on a straight-line basis for an operating lease.

Quickest way: Five-test scan for classification

Common mistakes in Introduction to Leases and Classification

• Classifying a lease by its name, such as treating a lease called 'rental agreement' as operating without testing it.

  Students go by the label in the question instead of the substance.

  Fix: Always run the tests. AS 19 classifies by transfer of risks and rewards, not by the title of the contract.

• Including contingent rent, maintenance charges or reimbursed taxes in MLP.

  Students add every amount the lessee pays under the contract.

  Fix: MLP excludes contingent rent, costs for services and taxes reimbursed to the lessor. Strike them out first.

• Using the same MLP for lessee and lessor.

  Students forget that the guarantee element depends on who gave it.

  Fix: Lessee's MLP adds residual value guaranteed by the lessee or a related party. Lessor's MLP also adds guarantees from a financially capable independent third party.

• Taking the lease term as the full period in the agreement, ignoring cancellability and renewal options.

  Students skip the definition of non-cancellable and reasonably certain.

  Fix: Take the non-cancellable period, and add renewal periods only when exercise is reasonably certain at inception.

• Saying a lease is finance only if title passes.

  Students link ownership with finance leases too tightly.

  Fix: Title may or may not pass in a finance lease. A lease for a major part of economic life or with PV of MLP near fair value can be finance even without a transfer of title.

• Treating the test percentages as fixed rules, such as '75% of life' or '90% of fair value'.

  Students import thresholds from other frameworks.

  Fix: AS 19 uses the words 'major part' and 'substantially all' and gives no percentages. Reason with the figures and state your judgement, unless the question gives a threshold.

Worked examples