An Example To Illustrate How To Classify A Lease As Finance Lease

Below example demonstrate how to classify a lease into a finance lease:

Question:

ABC Ltd enters a lease agreement on 1 January 2009 to have the right to use the asset for 10 years. The economic life of the asset is 11 years. The fair value of the asset is $12 million. The lessee agreed to pay $1.6 million annually for 10 years at the beginning of each year. The present value of the minimum lease payment is $10.5 million.

Required: How should the lease be classified?

Answer:

On the inception date 1 January 2009, the lease will be classified as a finance lease due to:

• the lease period is 10 years, which is 91% of the economiclife of the asset. Therefore it meets the criteria being the lease forms the major part of the economic life of the assets, even if its title is not transferred
• the present value of the minimum lease period is substantially all (87.5%) of the fair value of the asset

The asset will be depreciated over 10 years.