Office Lease Classification: Finance or Operating?
Which of the following statements is correct?
Office LLC should classify the lease as operating because the lease term is not for the major part of the economic life of the building so the lessor does not transfer substantially all the risks and rewards incidental to ownership of a leased office space.
Office LLC should classify the lease as operating because it is responsible for all repairs and office maintenance during the lease and any increase in property taxes.
Office LLC should classify the lease as finance because the change in the rent payment between the first five years and the second five years of the lease is not substantial.
Office LLC should classify the lease as finance because the lease term is for the major part of the economic life of the building.
Answer:
According to the given scenario, the correct statement is as follows: Office LLC should classify the lease as finance because the lease term is for the major part of the economic life of the building.
Explanation:
According to IFRS 16, there are two types of leases: finance lease and operating lease. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership.
If not, it is classified as an operating lease. In the given scenario, the lease term is ten years, while another office building with similar characteristics has an estimated useful life of 50 years. This implies that the lease term covers a major part of the economic life of the leased asset.
Therefore, the lease should be classified as a finance lease, as per the criteria mentioned under IFRS 16. As per the given scenario, the rent payable for the first five years is $5,000 per month, while the rent for the second five years increases to $6,000 per month.
This difference in rent is not a relevant factor to decide the classification of the lease. The clause in the contract that makes Office LLC responsible for any increase in property taxes is also not a relevant factor in classifying the lease as finance or operating.
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