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Which Leases Shall Be Recorded in Line With "Substance Over Form"?
Which Leases Shall Be Recorded in Line With "Substance Over Form"?
Finance lease – this is a lease that transfers substantially all the risks and rewards incident to
ownership of an asset to the lessee, while legal title does not necessarily need to be transferred.
Exactly this type of lease shall be recorded in line with substance over form principle.
Operating lease – this is a lease other than finance lease and is accounted for as regular rent.
1. The lease transfers the ownership of an asset to the lessee by the end of the lease term.
2. The lessee has an option to purchase the asset at a price sufficiently lower than its fair
value at the date of purchase (for example, lessee can purchase leased asset for 1 EUR at
the end of the lease term).
3. The lease term is for the major part of the economic life of the asset even if the title is
not transferred (for example, a car is leased for 3 years, while its economic life is 4
years).
4. At the inception of the lease, present value of the minimum lease payments comes
close to the fair value of the leased asset.
5. Leased assets are of such specialized nature that only the lessee can use them without
major modifications.
If any of these situations happens, then the lease is almost for sure a finance lease.
The amount of the accounting entry is lower of the fair value of the leased property and
the present value of the minimum lease payments.
2. Lease payments
Each lease payment also contains the interest, as the finance lease is in fact a loan.
Therefore:
Each fixed instalment therefore needs to be split between interest paid and loan
repayment. This split must be done as to produce a constant periodic rate of interest on
the remaining balance of the liability for each period.
Actuarial method does this best – it uses the interest rate implicit in the lease (internal
rate of return of the lease) to calculate the finance charge for the period based on the
amount of outstanding finance lease liability.
As the lessee acquires the non-current asset, it must be depreciated over the shorter of the
lease term and asset’s useful life. Depreciation entry is as follows: