Question

Operating and Capital Leases - The CEO of Smith & Sons, Inc., was considering a lease for a new administrative headquarters building. The building was old, but was very well located near the company’s principal customers. The leasing agent estimated that the building’s remaining useful life was ten years, and at the end of its useful life, the building would probably be worth $100,000. The proposed lease term was eight years, and as an inducement to Smith & Sons’ CEO to sign the lease, the leasing agent indicated a willingness to include a statement in the lease agreement that would allow Smith & Sons to buy the building at the end of the least for only $75,000. As the CEO considered whether or not to sign the lease, she wondered whether the lease could be accounted for as an off-balance-sheet operating lease. What would you advise her?

Answer 1

As per IFRS 16 Asset shall be classified as a financing lease if:

• the lease transfers ownership of the asset to the lessee by the end of the lease term
• the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised
• the lease term is for the major part of the economic life of the asset, even if title is not transferred
• at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset
• the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made

In given case maximum life of building is going to be used by Smith and after 8 year Smith and Sons has right to purchase the building.

Which clearly shows that its financing lease and not a off balance sheet.