BLM11230 – Lease accounting: lease classification: practical issues with borderline issues

The definition of a finance lease (and therefore of an operating lease) involves an element of judgment. For example

• what is the fair value of the asset? Valuers could take different views.
• what is the present value of the minimum lease payments? Calculating that sum could involve estimating future interest rates and also any residual value of the asset which the lessor could keep.

In short there is a fair amount of scope for taking a pessimistic or optimistic view of a range of possible numbers.

In simple terms, there may be little difference between an 89% operating lease and a 91% finance lease. Remember that the so-called ‘90% test’ in SSAP 21 is only indicative. The extent to which it is relied on will depend on the particular facts of the case, but it illustrates the point that the borderline between a finance lease and an operating lease is a fine one.

It follows that the borderline between finance leases and operating leases is open to exploitation in order to secure the advantages of 'off balance sheet' finance for the lessee. Furthermore, even without exploitation, as financing arrangements grow more sophisticated it becomes increasingly difficult – even with the best will in the world – to decide whether a lease is a finance lease or an operating lease.

It is also important to remember that the application of many anti-avoidance rules depends on whether or not the lease is accounted for as a finance lease. There can, therefore, be a tax incentive to ensure that a lease is structured so that it may be properly accounted for in a particular way – either as a finance lease, or as an operating lease, depending on what is required.

In addition, because there is an element of judgment in applying GAAP (and because the facts – especially concerning guarantees – could be very different) it is possible for a lessor and lessee to reach opposite conclusions. The lessor could regard the deal as a finance lease while the lessee could treat it as an operating lease.