Definition of Lease and its classification

Lease Definition and Scope:

A lease conveys the right to use an underlying asset for a period of time in exchange for consideration. At the inception of an arrangement both the parties should determine whether the contract contains a lease by assessing both of the following:

•       Whether there is an identified asset.
•    Whether the contract conveys the right to control the use of the identified asset in exchange for consideration for a period of time.

Exclusions from the lease standard:

•          Leases of inventory or of construction in progress.
•          Leases of intangible assets, including licenses of internal-use software.
•          Leases to explore for or use natural resources
•          Lease of biological assets
•     Service concession arrangements within the scope of ASC 853, service concession arrangements.

Leases Effective Date for ASC 842:

·         Earlier:

Public Business Entities (PBE’s)		Private & All Others
SEC Filers	All other PBE’s
January 2019	January 2019	January 2020

·         Now:

 On November 15, 2019, FASB officially delayed the above effective dates as below:

Public Business Entities (PBE’s)		Private & All Others
SEC Filers	All other PBE’s
January 2019	January 2019	January 2021

For official notification on this please click here

Exemption for short term leases:

A lessee may elect not to apply ASC 842 to short-term leases. If lessee elects the exemption then lease payments needs to be recognized in P&L on straight-line basis over the lease term (Following ASC 840 guidance).

Classification of leases:

We can classify leases broadly as below:

Finance Lease/Sale type:

A lease can be treated as Finance/Sale type lease when it satisfies any of the below conditions:

• Does the lease transfer ownership of the underlying asset to the lessee by the end of the lease term.
• Does the lease grant the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise?
• Is the lease term for a major part of the remaining economic life of the underlying asset?
• Is the present value of the sum of the lease payments and any residual value guaranteed by the lessee, that is not otherwise included in the lease payments, substantially all of the fair value of the underlying asset?
• Is the underlying asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

Direct Financing Lease (Only for lessor):

Direct finance lease is almost same as finance lease. However, in direct financing lease there will be a third party who will guarantee the residual value of the leased asset. Here the lessor’s only source of revenue will be interest income. Here the lessor will always be a bank or financial institution. This lease is just an alternative to the ordinary lending arrangement in which a borrower uses the loan proceeds to purchase an asset. Functionally direct financing lease is equivalent to loan.

Operating Lease:

If any of the five conditions stated above in finance lease are not satisfied then it will be considered as Operating Lease.

Author:
Pranay Kumar Chatakonda
CA, ACCA