IFRS -  Lease agreements normally considered to be finance leases

Lease classification is often complex, as the substance of arrangements can be unclear. Nevertheless, the following circumstances are usually indicative of finance leases.

a) Transfer of ownership at the end of the lease term to a lessee [IAS17.10(a)(R.05)].

The lease is usually a finance lease, as the lessee will have the use of the asset over its entire economic life. A transfer of ownership can be achieved where the lessor holds a put option requiring the lessee to acquire the asset, and the lessor is expected to exercise this option .

b) The lessee has a bargain purchase option [IAS17.10(b)(R.05)].

A bargain purchase option, if the lessee exercises it, is another means of obtaining ownership of the leased asset. A reference to an option at a fixed price, or by reference to the asset's depreciated cost, may indicate a bargain purchase option, which is likely to be less than the asset's fair value at exercise date, and likely to be exercised . A statutory right to buy the asset does not by itself result in the classification as a finance lease. Facts and circumstnces decide whether the right is a bargain or not

However, the financial incentive does not always determine the lessee's behaviour. Changed business circumstances may render a cheaply priced asset surplus to the lessee's requirements.

c) The lease term covers the major part of the asset's economic life [IAS17.10(c)(R.05)].

There might be a presumption (not conclusion) that the lease is a finance lease if a lessee has use of the leased asset for a major part of its economic life. The term major is not specified in the standard; however, leases that cover seventy five percent of an asset's useful life are usually finance leases, since proportionally more economic benefit is derived in the earlier years of an asset's life than in the later ones .

d) The present value of the MLP at the beginning of the lease amounts to substantially all of the fair value of the asset [IAS17.10(d)(R.05)].

Payments made by a lessee that are a substantial portion of a leased asset's fair value might be presumed to give rise to a finance lease .

e) The leased asset is constructed to the lessee's specification and could not be used by others without significant modification [IAS17.10(e)(R.05)] .

Such an asset will have limited market value, and the lessor will typically have to recover its initial investment during the primary lease term, or by giving the lessee a call option that it is likely to exercise. Both are likely to lead to finance lease treatment .