Classification of leases by the lessor

Learning objectives

• Explain that a lease is a finance lease if it transfers substantially all the risks and rewards incidental to ownership, and otherwise an operating lease, classification being made at the inception date.L1, L2
• Analyse the situations and indicators of a finance lease (transfer of ownership, bargain purchase option, major part of the economic life, present value close to fair value, specialised asset, losses on cancellation, fluctuations in the fair value of the residual, extension at a lower rent).L2, L3, L4
• Determine the classification of a lease of land and buildings, each element being assessed separately.L3, L4

Normative references

• IFRS 16 §61The lessor classifies each of its leases as either an operating lease or a finance lease.
• IFRS 16 §62A lease is a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset to the lessee; otherwise it is an operating lease.
• IFRS 16 §63Classification depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a finance lease: transfer of ownership by the end of the lease term; a purchase option at a price sufficiently lower than fair value for it to be reasonably certain, at the inception date, that it will be exercised; a lease term for the major part of the economic life of the asset; at the inception date, a present value of the lease payments amounting to at least substantially all of the fair value of the asset; an asset of such a specialised nature that only the lessee can use it without major modifications.
• IFRS 16 §64Indicators that could also lead to a finance lease: if the lessee can cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee; gains or losses from fluctuations in the fair value of the residual accrue to the lessee; the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
• IFRS 16 §65The examples and indicators in paragraphs 63 and 64 are not always conclusive: if it is clear from other features that the lease does not transfer substantially all the risks and rewards, it is classified as an operating lease, for example if ownership is transferred at the end of the lease for a variable payment equal to the asset's then fair value, or if there are variable lease payments as a result of which the lessor does not transfer substantially all of them.
• IFRS 16 §66Lease classification is made at the inception date and is reassessed only if there is a lease modification. Changes in estimates (economic life, residual value) or changes in circumstances (default by the lessee, for example) do not give rise to a new classification.
• IFRS 16 §B53Lease classification by a lessor is based on the extent to which the lease transfers the risks and rewards incidental to ownership of an underlying asset. Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions; rewards include the expectation of profitable operation over the asset's economic life and of gain from appreciation in value or realisation of a residual value.
• IFRS 16 §B54If the contract provides for the lease payments to be adjusted for specified changes occurring between the inception date and the commencement date (for example, in the cost of the asset or the lessor's cost of financing), the effect of those changes is deemed to have taken place at the inception date for classification purposes.
• IFRS 16 §B55When a lease includes both land and buildings elements, the lessor assesses the classification of each element separately applying paragraphs 62 to 66 and B53-B54, taking into account that land normally has an indefinite economic life.
• IFRS 16 §B56Whenever necessary, the lessor allocates the lease payments (including any lump-sum upfront payments) between the land and buildings elements in proportion to the relative fair values of the leasehold interests in each element at the inception date. If the allocation cannot be made reliably, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases.
• IFRS 16 §B57When the amount of the land element is immaterial, the lessor may treat the land and buildings as a single unit for the purpose of classification applying paragraphs 62 to 66 and B53-B54, the economic life of the buildings then being regarded as the economic life of the entire underlying asset.

Original summaries of the paragraphs (reference register), never a quotation of the standard.

27 questions

• On 1 February 20X2, Grutia and the lessor Dalvia commit to the principal terms of a lease of a crane (inception date). Dalvia makes the crane available to Grutia on 1 May 20X2 (commencement date). On which dates does Dalvia classify the lease and Grutia recognise the right-of-use asset and the lease liability?L2
• For a lessor, what is a finance lease?L1
• Under IFRS 16, the lessee classifies each of its leases as an operating lease or a finance lease, and recognises a right-of-use asset only for the latter.L1
• Which of the following operations take place at the commencement date of the lease, and not at the inception date? (several answers)L2
• For a lessor, each lease must be classified in one of two categories only: finance lease or operating lease.L1
• IFRS 16 requires the lessor to classify as a finance lease any lease whose term covers at least 75% of the economic life of the underlying asset.L1
• Which criterion leads a lessor to classify a lease as a finance lease rather than an operating lease?L1
• When does the lessor classify a lease, and when is that classification reassessed?L2
• The lessor Orvalis classified a crane lease as a finance lease. Two years later, without any modification of the lease, it revises upwards the estimated economic life of the crane, so that the lease term no longer covers the major part of it. Orvalis must reclassify the lease as an operating lease.L2
• Which of the following situations would normally, individually or in combination, lead the lessor to classify a lease as a finance lease?L2
• Calvenor, a lessor, reviews the clauses of a forklift truck lease. Which clauses are indicators that could also lead to a finance lease?L2
• To assess the transfer of the risks and rewards incidental to ownership, the lessor distinguishes risks from rewards. Which of the following is a reward rather than a risk?L2
• The lessor Tervane leases a hydraulic press whose fair value at the inception date is {fair_value}. The lessee pays {number_of_payments} annual payments of {annual_payment}, in arrears; no residual value is guaranteed. For the classification analysis, Tervane discounts the lease payments at {discount_rate} (case datum). Compute the present value of the lease payments at the inception date, rounded to the nearest euro.L2
• Lumeria, a lessor, makes available a server rack with a fair value of {fair_value} at the inception date. The lease provides for {number_of_payments} annual payments of {annual_payment}, in advance, the first one at the commencement date. The lessee guarantees to the lessor a residual value of {guaranteed_residual} at the end of the fourth year. The discount rate used for the classification analysis is {discount_rate} (case datum). Compute the present value of the lease payments at the inception date, rounded to the nearest euro.L3
• The lessor Domaris leases for 25 years a plot of land and the warehouse built on it, for a single annual payment of {annual_payment}. To classify each element separately, Domaris must allocate this payment. At the inception date, the fair value of the leasehold interest in the land is {land_interest_fv} and that of the leasehold interest in the building is {building_interest_fv}. Compute the annual share of the payment allocated to the land and the share allocated to the building.L3
• The property company Belcastre leases out a hotel site made up of land and a building. At the commencement date, the lessee pays a lump-sum upfront payment of {upfront_payment}, then an annual payment of {annual_payment}. At the inception date, the fair values of the leasehold interests amount to {land_interest_fv} for the land and {building_interest_fv} for the building. Compute the share of the upfront payment and the share of the annual payment allocated to the building.L4
• Sarvel, a lessor, leases for 40 years a plot of land and the office building constructed on it. The economic life of the building is estimated at 45 years; the land represents a significant share of the value of the whole. The lease provides for neither transfer of ownership nor a purchase option, and the lease payments can be reliably allocated between the two elements. Which classification approach is appropriate?L3
• The lessor Quintal leases a plot of land and the factory built on it. Lacking comparable transactions, it cannot reliably allocate the lease payments between the two elements. The analysis of the factory shows finance lease characteristics, and nothing clearly establishes that both elements would be operating leases. How should the lease be classified?L3
• The lessor Montrel leases for 4 years a flight simulator whose economic life is estimated at 15 years. At the end of the lease, ownership of the simulator transfers to the lessee for a variable payment equal to the simulator's fair value at that date. The payments over the term cover a small part of the initial fair value, and no other clause transfers any risk or reward to the lessee. Which classification is appropriate?L4
• The lessor Altiva designs and leases to the Ferrandis group a test bench configured for its production line only. No other user could use it without major modifications. Altiva keeps legal ownership of the bench. What conclusion should be drawn from this feature?L3
• The lessor Pradelle leases a construction machine for 5 years. The lessee may buy it at the end of the lease for 5,000, whereas the expected fair value of the machine at that date is about 60,000. How is this option taken into account in the classification?L3
• The accounting manual of the Holdenor group, a lessor of industrial equipment, states: finance lease if the term reaches 75% of the economic life or if the present value of payments reaches 90% of fair value; otherwise operating lease. A new lease has a term equal to 70% of the economic life and a present value equal to 88% of fair value. The lessee bears the lessor's losses if it cancels, and it can extend the lease for 3 years at a rent substantially lower than market. The controller concludes on an operating lease by applying the manual. Write a critical memo on this policy and on the conclusion reached.L4
• Brivane, a lessor, classified at the inception date a 7-year lease of a printing press as an operating lease. In the third year: Brivane sharply lowers its estimate of the residual value of the press; the lessee is in difficulty and has paid two instalments late; no clause of the lease has been modified. The chief financial officer proposes to reclassify the lease as a finance lease to reflect the new situation. Give and justify your opinion.L4
• Hexaline leases industrial presses under finance leases for six years. At the end of the second year, its annual review leads it to lower the estimate of the unguaranteed residual value of one of the presses, which was included in the gross investment. No other term of the contract changes. What treatment must Hexaline apply?L3
• A restaurant group, Tavira, is the lessee of commercial premises for 15 years and subleases part of them to a franchisee. The head lease is not accounted for under the short-term lease exemption. Which of the following statements on Tavira's classification of the sublease are correct?L3
• Kelmar is the lessee of an office building for 20 years; the economic life of the building is estimated at 50 years. At the start of year 3, Kelmar subleases the entire building to Doriel for the remaining 18 years of the head lease, without any particular option or guarantee. Kelmar's controller proposes an operating lease, on the grounds that 18 years are only a small part of the 50-year life of the building. Which analysis do you adopt?L4
• You are preparing the classification file for a sublease granted by Ardoval, the lessee of a production line for 8 years. Which information is relevant for this classification?L4