CIMA F3 Syllabus B. Sources of long term funds - Leases - Introduction - Notes ^{13 / 15}

A lease is a commercial arrangement whereby an asset owner conveys the right to use the asset in return for a specified payment by the user over an agreed period of time.

In simple terms, a finance lease is where the LESSEE takes the majority of the risks and rewards of the underlying asset.

Therefore with a finance lease the lessee would show the asset on their SFP (and the related finance lease liability).

When classifying look for substance rather than the form.

Finance Lease Indicators

• The lessee gets ownership of the asset at the end of the lease term

• The lessee can buy the asset at such a low price that it is reasonably certain that the option will be exercised;

• The lease term is for the major part of the economic life

• The PV of the lease payments is substantially the fair value of the leased asset; and

• Only the lessee can use the asset as it is so specialised

Other possible finance lease indicators

• If the lessee cancels the lease, he has to pay the lessor’s losses

• The lessee gets any residual value gains/losses and

• The lessee can lease for a secondary period at a cheap rent

Normally separately classified

The minimum lease payments are allocated between the land and buildings elements in proportion to their relative fair values.

• Land = Operating lease (unless title passes to the lessee at the end of the lease term)

• Buildings = Operating or finance lease (by applying the classification criteria in IAS 17)

The classification of leases is a key issue in corporate reporting. From a lessees point of view, classifying as a finance lease will increase gearing and decrease ROCE (as there’s more capital employed due to the finance lease liability). Interest cover will also decrease.

As the SFP shows more liability, future borrowing will be harder to come by and current loan covenants may be breached. The level of perceived risk may increase, loan covenants may be compromised and an entity’s future borrowing capacity may be restricted.

UK studies have revealed that average operating lease commitments are over ten times that of reported finance lease obligations.