## Classification Test: Finance Lease or Operating Lease?

Under AS 19, a lease is classified as a finance lease if it transfers substantially all the risks and rewards of ownership to the lessee. At least one of the following five conditions must be satisfied:

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### The 5 Conditions (any ONE is sufficient)

#	Condition	Practical Indicator
1	Ownership transfer at end of lease term	Title passes to lessee
2	Bargain purchase option – lessee can buy at below-market price	Price sufficiently lower than expected FMV
3	Lease term covers major part of the asset's useful life	Thumb rule: 75% of economic life (ICAI practice uses 60% in some illustrations)
4	PV of MLP ≥ substantial part of fair value of asset	Thumb rule: ≥ 90% of fair value
5	Specialised nature – only the lessee can use the asset without major modification	Unique/custom-built assets

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### Decision Flow

```

Check condition 1 → met? → Finance Lease

↓ No

Check condition 2 → met? → Finance Lease

↓ No

Check condition 3 → met? → Finance Lease

↓ No

Check condition 4 → met? → Finance Lease

↓ No

Check condition 5 → met? → Finance Lease

↓ No

→ Operating Lease

```

---

### Condition 4 Calculation

```

PV of MLP

───────── × 100 ≥ 90% → Finance Lease

Fair Value

```

Worked example

### Example 1

Illustration 11 – Classify the lease

Check Condition 1: Ownership transferred? → No

Check Condition 2: Purchase option? → No

Check Condition 3: Term/Life = 3/4+ = ~75% → Borderline (question uses 60% as threshold) → Not clearly met

Check Condition 4:

PV of MLP = ₹9,24,870 (computed)

PV of MLP / Fair Value = 9,24,870 / 10,00,000 = 92.48% ≥ 90% → YES → Finance Lease

Conclusion: Condition 4 is satisfied → Finance Lease

Note: The question specifies 60% as 'major part' threshold for condition 3, illustrating that the examiner can state a specific percentage.

⚠️ Common exam mistakes

Assuming ALL five conditions must be met – only ONE needs to be satisfied for finance lease classification.
Using the full asset life rather than the economic/useful life for condition 3 (lease term vs life ratio).
Comparing undiscounted MLP (face value) to fair value in condition 4 instead of PV of MLP.
Treating 75% and 90% as absolute statutory thresholds – AS 19 uses 'major part' and 'substantial part'; the percentages are guidance and the question may specify a different figure.
Forgetting to include GRV in MLP when computing PV for condition 4.

Bare-Act text Para 5 · AS 19 – Leases (ICAI) · click to expand

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred. Situations that would normally lead to a lease being classified as a finance lease include: (a) the lease transfers ownership of the asset to the lessee by the end of the lease term; (b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable that it is reasonably certain, at the inception of the lease, that the option will be exercised; (c) the lease term is for the major part of the economic life of the asset even if title is not transferred; (d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and (e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

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AS 19 Leases – Checking Finance Lease vs Operating Lease: 5 Conditions

Worked example

⚠️ Common exam mistakes