Lease classification

Consider the following scenarios:

(a) Entity A leases a motor vehicle from Entity B for a non-cancellable three-year period. At the inception of the lease, the lease was assessed as an operating lease. The lease did not contain any explicit option in the lease contract to extend the term of the lease. After 2 years, Entity A applies to Entity B to extend the lease for a further two years after the initial three-year period is complete. This extension is granted by the leasing company on an arm’s length basis.

Entity A’s negotiations result in a renewed (i.e. new) lease, not a change in the provisions of the original lease. This does not affect the classification of the original lease. Although the date of inception of the new lease would be the date on which negotiations were completed, the new lease would not be accounted for until its commencement, which will be after the termination of the original lease.

(b) Entity C leases a machine tool from Entity D for 5 years, expecting to purchase a new asset after the lease expires. After 3 years, Entity C concludes that it is more economically viable for it to lease the asset from Entity D for a total of 8 years. The lessor agrees to revised lease terms and the lease is extended by 3 years, giving a total term of 8 years. At the same time the lease payments for years 4 and 5 are revised so that Entity C will pay a new rental for each of the years 4 to 8.

This is a lease modification as it has resulted in a change to the terms of the original lease. The entity will have to assess whether the revised lease is an operating or finance lease.

(c) Entity E leases an asset from Entity F for 10 years. The lease includes a purchase option under which Entity E may purchase the asset from Entity F at the end of the lease. The exercise price is fair value. Entity E is required to give notice of its intention to purchase no later than the end of the eighth year of the lease (since this arrangement allows Entity F time to market the leased asset for sale). On inception, Entity E classifies the lease as an operating lease, believing it was not reasonably certain that it would exercise the option. Near the end of the eighth year of the lease, Entity E serves notice that it will purchase the asset, thereby creating a binding purchase commitment.

Entity E exercises an option that was not considered reasonably certain at inception; this is a change in estimate and does not affect lease classification. Many entities would consider the arrangement to be executory at the time that the notice is given even though there is a legal obligation to make the option payment and therefore would account for the purchase option only when it is exercised.

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