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IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company

Tarang Ltd leases machinery from a lessor for most of the asset's economic life. The lessee bears the risks of obsolescence and maintenance, and the present value of the lease payments is close to the asset's fair value. How is this arrangement best classified?

It is a finance lease, because substantially all the risks and rewards of ownership pass to the lessee. The lease covers most of the asset's life, the present value of payments approximates fair value, and the lessee bears obsolescence and maintenance, regardless of legal title.

  1. AOperating lease, because legal title stays with the lessor
  2. BFinance lease, because substantially all risks and rewards of ownership pass to the lesseeCorrect
  3. CSale and leaseback, because the asset is transferred
  4. DHire purchase, because the lessee must buy the asset at the end
  5. Operating lease, because payments are made periodically

Explanation

Classification depends on substance, not legal title. Lease term covering most of the economic life, present value of payments near fair value and the lessee bearing risks all indicate a finance lease. Legal title and periodic payments do not decide this.

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