FRS 116 Leases – Classifying the Leases
If you or your company lease something to someone else, then you are the lessor in the lease. Lessor refers to an entity which gives the right of using an underlying asset for a certain period in exchange of consideration. It is the lessor’s responsibility to classify the leases, whether they are finance leases or operating leases. These two different types of leases require different accounting treatments specified in FRS 116: Leases. Hence, if you have doubts about their classifications and accounting treatments, please feel free to contact an accounting firm in Singapore.
Compared to the term of the contract, the substance of transaction plays a more significant role in the classification of leases. For a lease that transfers all rewards and risks incidental to the ownership of an underlying asset substantially, the lease is a finance lease. If a lease did not fulfil this requirement, then it falls into the category of an operating lease.
There are some examples of conditions that make a lease to be classified as a finance lease if they happen together or individually. If the lease transfers the underlying asset’s ownership to the lessee as the lease term ends, then it is a finance lease. The other situation is when the lessee has an option of purchasing the underlying asset, and the price is predicted to be sufficiently cheaper than its fair value when the lessee can exercise the option. This is for it to be reasonably certain that it will implement that option at the inception date.
Also, a lease should be a finance lease if the lease term has made up a big part of the underlying asset’s economic life, although the title is not transferred. If the present value of the sum of lease payments is at least substantially the full amount of the underlying assets’ fair value, then the lease is a finance lease. The last example of the situation that makes a lease to become a finance lease is if the nature of the underlying asset is so specialised that only the lessee is capable of using it without needing significant modifications.
Apart from the situations mentioned above, some other indicators may cause a lessor to categorise a lease as a finance lease if they happen together or individually. Those indicators include cases where the lessee needs to be responsible for the lessor’s losses arising from a cancellation of a lease if the lessee may cancel the lease. Another indicator is that the gains or losses that arise from the fluctuation in the residual’s fair value are accrued to the lessee. If the lessee can continue the lease for a subsequent period at a rent which is significantly lower than the market rent, the lease should be a finance lease too.
However, note that the indicators and examples mentioned above are not always conclusive. To determine whether a lease is an operating lease, the lessor should know whether a lease transfers all the rewards and risk incidental to the ownership of an underlying asset significantly. If the lease does not, then it is an operating lease.
An example for the situation where a lessor should classify a lease as an operating lease is when the underlying asset’s ownership transfers for a variable payment that has the same amount of its fair value at the end of the lease. Besides, in some cases, there may be variable lease payments as the lessor does not transfer all the risk and rewards significantly. Therefore, such leases should be categorised as an operating lease.
The lessor should classify the lease at the inception date. Besides, he should reassess its classification only if there is a modification in it. Changes in circumstances and estimates would not lead to a new lease classification.