Substance over form rule:The IFRS Conceptual Framework in paragraph 35 states that ‘if information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. This is called Substance over form rule.
The substance transactions or other events is not always consistent with that which is apparent from their legal or contrived form’. Thus, all aspects and implications of an arrangement or transaction should be evaluated to determine its substance, with weight given to those aspects and implications that have an economic effect, prior to accounting for that event or transaction.
Whether a lease is classified as a finance lease or an operating lease depends on the substance of the lease arrangement rather than the form of the contract. Thus, if ‘in substance’ substantially all of the risks and rewards incident with ownership are transferred from the lessor to the lessee the arrangement giving rise to a finance lease.
How to calculate Minimum Lease Payments (MLP) :
See IAS 17, paragraph 4, the definition can be expressed as follows:
Minimum lease payments (MLP) =
(i) Payments over the lease term –>The lease payments are simply the total amounts payable under the lease agreement.
+ (Plus) (ii) Guaranteed residual value –>The guaranteed residual value is that part of the residual value of the leased asset guaranteed by the lessee or a third party related to the lessee. The lessor will estimate the residual value of the leased asset at the end of the lease term based on market conditions at the inception of the lease, and the lessee will guarantee that, when the asset is returned to the lessor, it will realize at least that amount.
+ (Plus) (iii) Bargain purchase option –>A bargain purchase option is a clause in the lease agreement allowing the lessee to purchase the asset at the end of the lease for a preset amount, significantly less than the expected residual value at the end of the lease term
– (Minus) (iv) Contingent rent –> Scheduled lease payments may be increased or decreased during the lease term by the occurrence of events specified in the lease agreement. Additional payments arising from such changes are called contingent rent.
– (Minus) (v) Reimbursement of costs paid by the lessor –>Lease payments may include two components: a charge for using the asset, and a charge to reimburse the lessor for operating expenses paid on behalf of the lessee. These operating amounts include insurance, maintenance, consumable supplies, replacement parts and rates.