XYZ Limited (the company) leases a manufacturing plant from ABC Limited for 10 years. The useful life of the plant is 20 years. According to the lease agreement, the company has an option to purchase the plant from ABC Limited at the end of lease term, at its fair value. The agreement requires the company to give a notice of its intention to purchase the plant no later than the end of the eighth year of the lease. On inception, the company classifies the lease as an operating lease because there was a reasonable commercial possibility that it will not exercise the option. At the end of the seventh year of the lease, the company serves a notice that it will purchase the plant, thereby creating a binding purchase commitment.
Is the company required to reassess the lease classification due to the exercise of the purchase option?
Paragraph 10 of AS 19 Leases requires the lease classification to be made at the inception of the lease.” It further states that “…If at any time the lessee and the lessor agree to change the provisions of the lease, other than by renewing the lease, in a manner that would have resulted in a different classification of the lease … the revised agreement is considered as a new agreement over its revised term. Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased asset) or changes in circumstances (for example, default by the lessee), however, do not give rise to a new classification of a lease for accounting purposes.”
In this case, the original lease agreement contained the purchase option. However, its exercise was not considered probable at the inception of the lease because the option is exercisable at fair value. The lessee has decided to exercise the purchase option toward the end of the lease term. This indicates a change in estimate, intention or circumstances, as against any change in the terms of the agreement. Therefore, in the fact pattern above, the company will continue to classify the lease as an operating lease, till it actually exercises the purchase option. On exercise of the purchase option, the company will account for the fixed asset purchase at the option exercise price.