Lessor lease classification: finance or operating lease

Classification decides the whole shape of a leasing company's statements. A finance lease removes the vehicle, machine or building from the lessor's books and replaces it with a lease receivable that earns finance income at a constant rate; an operating lease keeps the asset on the books, with depreciation, impairment testing and straight-line rental income. Getting it wrong moves amounts between assets, receivables, revenue and depreciation, changes the income profile across the lease term, and changes which impairment model applies (IFRS 9 expected credit losses for the receivable, IAS 36 for the asset). Leases of real estate add a second trap: land and buildings must be assessed as separate elements, so a single 'finance lease' label on a whole property is often wrong.

Does the lease transfer ownership to the lessee by the end of the term, or contain a purchase option priced so far below expected fair value that exercise is reasonably certain at inception? Does the lease term cover the major part of the asset's economic life, and does the present value of the lease payments (including residual value guarantees from the lessee, its related parties or a financially capable third party) amount to substantially all of the asset's fair value? Is the asset so specialised that only this lessee can use it without major modification? Who bears losses on cancellation, and who gains or loses from fluctuations in the residual value? For property leases, has the land element been assessed separately from the buildings element, and how were payments allocated between them? Was classification made at inception and reassessed only on a modification, not each year?

1. Classify each lease at inception date as a finance lease if it transfers substantially all the risks and rewards incidental to ownership, otherwise as an operating lease; substance prevails over the legal form and the title held by the lessor.
2. Work through the indicators: transfer of ownership, a purchase option reasonably certain of exercise, lease term for the major part of economic life, present value of lease payments amounting to substantially all of fair value, and a specialised asset; then the supplementary indicators on cancellation losses, residual value gains or losses and secondary-period rentals at below-market rates.
3. Treat the indicators as evidence, not a mechanical test: if other features show that substantially all risks and rewards are not transferred (for example a residual value the lessor clearly bears), the lease is operating.
4. For leases of land and buildings, classify each element separately; land normally has an indefinite life, so the land element is usually an operating lease unless title is expected to pass.
5. Allocate the lease payments between land and buildings in proportion to the relative fair values of the leasehold interests in each element at inception; if they cannot be allocated reliably, classify the whole lease as a finance lease unless both elements are clearly operating, in which case the whole is operating.
6. If the land element is immaterial, the land and buildings may be treated as a single unit and classified by reference to the buildings' economic life.
7. Do not reclassify for later changes in estimates (residual value, economic life) or changes in circumstances (lessee default); reassess only when the lease is modified.

Classification itself has no measurement, but its inputs do: the fair value of the underlying asset at inception, the economic life, the lease payments as defined in IFRS 16 (fixed and in-substance fixed payments less incentives, index-linked payments, a purchase option price if reasonably certain, termination penalties, and residual value guarantees from the lessee or qualifying third parties), and the interest rate implicit in the lease used to discount them. 'Major part' and 'substantially all' are not defined numerically in IFRS 16; an entity may use internal thresholds as a starting point, but the conclusion must still reflect all the facts. For land and buildings, the allocation key is the relative fair value of the leasehold interests, not the relative fair values of the land and the building themselves.

Disclose: (1) the accounting policy for lease classification, including how the indicators are applied and any internal thresholds used as a starting point; (2) significant judgments in classifying leases, especially property leases split into land and buildings and leases with residual value guarantees from third parties; (3) finance lease income split into selling profit or loss, finance income on the net investment and income from variable payments not included in the net investment; (4) operating lease income, separately showing variable payments not linked to an index or rate; (5) the maturity analyses required for finance and operating lease payments receivable.

• Classifying by legal title, so that every lease is 'operating' because the lessor keeps title, or every lease is 'finance' because the product is marketed as finance leasing
• applying a 75% or 90% threshold mechanically and ignoring other features
• treating a building and its land as one finance lease when title does not pass
• allocating payments using the fair values of the land and building instead of the leasehold interests
• ignoring residual value guarantees from manufacturers or dealers, which can turn a lease into a finance lease for the lessor
• reclassifying a lease because the lessee defaulted or the residual estimate changed