Classification of Leases
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. All other leases are classified as operating leases. Classification is made at the inception of the lease.
Accounting by Lessees
- At commencement of the lease term, finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments (discounted at the interest rate implicit in the lease, if practicable, or else at the entity’s incremental borrowing rate).
- Finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability (the finance charge to be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability).
- The depreciation policy for assets held under finance leases should be consistent with that for owned assets. If there is no reasonable certainty that the lessee will obtain ownership at the end of the lease — the asset should be depreciated over the shorter of the lease term or the life of the asset. For operating leases, the lease payments should be recognised as an expense in the income statement over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern of the user’s benefit.
Now Read: Valuation of Shares, Goodwill & Members Interest
Accounting by Lessors
The following principles should be applied in the financial statements of lessors:
- At the commencement of the lease term, the lessor should record a finance lease in the balance sheet as a receivable, at an amount equal to the net investment in the lease.
- The lessor should recognise finance income based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment outstanding in respect of the finance lease.
- Assets held for operating leases should be presented in the balance sheet of the lessor according to the nature of the asset.
- Lease income should be recognised over the lease term on a straight-line basis unless another systematic basis is more representative of the time pattern in which use benefit is derived from the leased asset is diminished.
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