Criteria Finance Lease

A finance lease, also known as a capital lease, is a type of lease where the lessee essentially assumes all the risks and rewards of ownership of the leased asset. It's treated more like a purchase than a traditional operating lease. Several criteria are used to determine if a lease qualifies as a finance lease. These are outlined primarily in accounting standards like IFRS 16 and ASC 842. Meeting even one of these criteria typically signifies that the lease is a finance lease.

Transfer of Ownership: The most straightforward criterion is if the lease transfers ownership of the asset to the lessee by the end of the lease term. If the agreement explicitly states that the lessee will own the asset once the lease period concludes, it unequivocally indicates a finance lease.

Bargain Purchase Option: A bargain purchase option (BPO) exists when the lessee has the option to purchase the asset at a price significantly lower than its expected fair value at the time the option becomes exercisable. The likelihood of the lessee exercising this option must be reasonably certain. This demonstrates the lessee's intent to acquire the asset at a reduced cost, characteristic of ownership.

Lease Term Major Part of Asset's Economic Life: If the lease term covers a major part of the asset's economic life, even without a transfer of ownership, it suggests that the lessee is using the asset for the majority of its useful life. While the exact percentage constituting a "major part" varies depending on the accounting standard, a common benchmark is 75% or more. This criterion reflects that the lessee is deriving nearly all of the asset's economic benefits.

Present Value of Lease Payments Substantially All of Asset's Fair Value: Another significant criterion is whether the present value of the minimum lease payments, at the commencement of the lease, amounts to substantially all of the asset's fair value. Again, the definition of "substantially all" is somewhat subjective, but a common threshold is 90% or more. This indicates that the lessee is effectively paying for the asset over the lease term.

Specialized Nature of the Asset: If the asset is of such a specialized nature that only the lessee can use it without major modifications, it suggests that the asset's value is tied directly to the lessee's operations. This implies that the lessee is essentially bearing the risks and receiving the rewards of ownership, even if the title remains with the lessor. The asset's lack of alternative use reinforces the notion that the lessee controls its destiny.

In summary, the determination of a finance lease relies on assessing whether the lessee effectively controls the asset and bears the associated risks and rewards. The criteria involving transfer of ownership, bargain purchase options, lease term as a major part of the economic life, present value of lease payments exceeding fair value, and the specialized nature of the asset, all point towards a lease being classified as a finance lease. Careful evaluation against these criteria is crucial for proper accounting and financial reporting.