In the case of a lease of land and building where title to the land is not transferred, the lease is generally treated as if:
a. Both land and building are finance leases
b. Both land and building are operating leases
c. Land is operating lease; building is finance lease
d. Land is finance lease; building is operating lease
The correct answer and explanation is :
The correct answer is b. Both land and building are operating leases.
Explanation:
In accounting and finance, when a lease involves land and buildings, the classification of the lease (as a finance lease or operating lease) depends on certain criteria set out in lease accounting standards, such as IFRS 16 or ASC 842 under U.S. GAAP. These standards aim to determine whether the lease is primarily a means of financing or a means of using the property without transferring ownership.
For a lease to be classified as a finance lease, it typically has to meet certain criteria, such as:
- The lease term covers the majority of the asset’s useful life.
- The present value of the lease payments is substantially equal to or greater than the fair value of the asset.
- The lessee has an option to purchase the asset at a bargain price at the end of the lease term.
- Ownership of the asset is transferred to the lessee by the end of the lease term.
When title to the land is not transferred in the lease, it suggests that the lessee does not obtain ownership or significant control over the property during or after the lease term. This would typically exclude the lease from being classified as a finance lease.
In this case, both land and the building are treated as operating leases because the lessor retains ownership and the lessee only has the right to use the property for a specified period without transferring significant risks or rewards associated with ownership.
Under IFRS 16, which applies to leases entered into on or after January 1, 2019, almost all leases are considered finance leases, with a few exceptions. However, if the lease does not transfer ownership and does not meet the criteria for a finance lease, it will be treated as an operating lease.
Thus, the answer is b because, when title is not transferred, neither the land nor the building is typically seen as a finance lease, leading both to be classified as operating leases.