According to IAS 17 two types of leases are identified namely Finance lease and Operating lease. The distinction between the two primarily resulted from the implications of one of the important accounting concept Substance over form.
Finance lease is a lease agreement in which substantially all the risks and rewards incidental to ownership of an asset are transferred to the lessee from the lessor. Where lessee is the person who acquired an asset from lessor for use and lessor is the person who is the owner of the asset and has handed over the asset to lessee to earn rentals.
On the other hand operating lease is a lease agreement which is NOT a finance lease. In short, a lease agreement in which risks and rewards associated with the asset are not transferred to the lessee and stays with the owner of the asset i.e. lessor.
Even though the lessor is the rightful owner of the asset and most often owners are responsible to bear any loss and obtain economic benefits associated with the asset but sometimes the risks and rewards associated with the assets are transferred to another person by the owner himself without transferring the title of ownership of the asset. Same is the case with the finance lease.
In simplest words, transfer of risks and rewards MEANS transfer of control of the asset. And from the definition and recognition principle of the asset we understood that it is the control of the asset that is important and not the ownership of the asset that determines the rightful person to report the asset in his books of account.
And from this we can understand that under finance lease the risks and rewards (control) of the asset are transferred to lessee therefore, lessee will write the asset in his books even though he is not the owner.
But under operating lease risks and rewards (control) of the asset are NOT transferred therefore, the lessor, who is the owner of the asset, will write the
asset in his books of accounting.
Risk is simple the risk of bearing the losses connected with the asset or lease agreement. For example the person who is responsible for the following losses or expenses is the person who is bearing the risks:
- person responsible for upkeep of asset i.e. repairs or
- person responsible for securing the asset i.e. insurance premium or
- the person who will bear the loss in case asset is stolen
- possible losses from idle capacity
- devaluation in asset because of technological obsolescence
- fluctuations in returns because of changing economic conditions
Reward simply means economic benefits that can be rendered from the asset. For example the person who is responsible for the following benefits is person enjoying the benefits from the assets:
- earning revenue profitably by selling goods produced, constructed by using the asset
- earning rental income by letting or sub-letting the asset
- appreciation in the value of asset (revaluation gain)
- appreciation in the residual value (sales value) of asset
SUBSTANTIAL Risks and Rewards INCIDENTAL to OWNERSHIP!
Substantial means significant or in other words almost all of them. Incidental to ownership means something that is primarily associated with the ownership. So we understood that almost all of such kinds of risks and rewards that primarily resulted from the ownership of the asset must be transferred to constitute a transfer of control. And it is the control that determines the type of lease agreement.
Care must be exercised in categorizing the risks and rewards as connected with the ownership. Not every reward and risk is incidental to ownership. There are only few risks and rewards which determines the control of the asset and if substantial amount of those risks and rewards is transferred only then a lease will be treated as finance lease. For example, a lessee may earn revenue by using the asset but he may not have the right to recognize revaluation gain of the asset.