Under international financial reporting standards, a lease is an arrangement where the lessor agrees to allow the lessee to use an asset for a stated period of time in exchange for one or more payments. A finance lease is one in which the lessee assumes substantially all risks and rewards associated with the asset, while an operating lease is any lease other than a finance lease. Examples of situations that could lead to a lease being classified as a finance lease are:
- Additional lease. The lessee can continue the lease for an additional period at a rate substantially lower than the market rate.
- Cancellation. If the lessee can cancel the lease, the lessee pays the lessor's losses associated with the cancellation.
- Fair value changes. Gains or losses from fair value changes accrue to the lessee.
- Ownership. The lease transfers asset ownership to the lessee by the end of the lease.
- Present value. The present value of minimum lease payments substantially equals the asset's fair value at lease inception.
- Purchase option. There is an option for the lessor to purchase the asset at a price expected to be sufficiently below fair value on the option date as to make it reasonably certain that the lessee will exercise the option.
- Specialized nature. The asset is so specialized that only the lessee can use it without major modifications.
- Term. The lease term covers the major part of the economic life of the asset, even if title is not transferred.
These examples are not always conclusive, so if other features of a lease agreement make it clear that the lease does not transfer substantially all risks and rewards of ownership to the lessee, you should classify it as an operating lease.