FRS 102: Leasing transactions

One of the most topical debates at the moment, certainly among the International Accounting Standards Board, is the issue of leasing explains Steve Collings. 

Leases have always posed a problem for the profession because of their subjective nature and the ability to manipulate leasing transactions to achieve a desired outcome (commonly referred to in the profession as ‘off balance sheet finance’). This article takes a look at leasing in the context of FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and also takes a brief look at the IASB’s proposals that may affect companies in the future.

Leasing is dealt with in FRS 102 in Section 20 Leases. At the outset this particular section confirms that it does not deal with the following types of leasing transactions:

• Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources (see Section 34 Specialised Activities)
• Licensing agreements for such items has motion picture films, video recordings, plays, manuscripts, patents and copyrights (see Section 18 Intangible Assets other than Goodwill)
• Measurement of property, plant and equipment held by lessees that is accounted for as investment property and measurement of investment property provided by lessors under operating leases (see Section 16 Investment Property)
• Measurement of biological assets held by lessees under finance leases and biological assets provided by lessors under operating leases (see Section 34)
• Leases that could lead to a loss to the lessor or the lessee as a result of non-typical contractual terms

Finance and operating leases

Section 20 still determines the classification of a lease in much the same way as SSAP 21 Accounting for Leases and Hire Purchase Contracts. The overarching principle in the determination of whether a lease is financing or operating is considered in light of the substance of the arrangement – in other words looking at who bears the risks and rewards of ownership of the asset subjected to the lease.

When, substantially, all the risks and rewards incidental to ownership of the asset are transferred from the lessor to the lessee, this will give rise to a finance lease. The asset will appear on the company’s balance sheet (statement of financial position) together with a corresponding finance lease creditor. Where the risks and rewards of ownership remain with the lessor, the lease is classified as an operating lease and rentals are charged to profit or loss as incurred. This is the same accounting treatment as we currently see in SSAP 21 (and the FRSSE (effective April 2008)).

The guidance notes to SSAP 21 contain a 90% test whereby should the present value of the minimum lease payments that the lessee is required to pay equate to 90% or more of the fair value of the leased asset then this will give rise to a finance lease. However, Section 20 does not contain any 90% benchmark that we currently see in SSAP 21; instead it offers five examples of situations that individually, or in combination, would normally lead to a lease being classified as a finance lease, and a further three indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease. The first five are as follows:

• The lease transfers ownership of the asset to the lessee by the end of the lease term
• 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 for it to be reasonably certain, at the inception of the lease, that the option will be exercised
• The lease term is for the major part of the economic life of the asset even if title is not transferred
• 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
• The leased assets are of such a specialised nature that only the lessee can use them without major modifications

You may note that the fourth bullet point above refers to the term ‘substantially all’. This is the term that has essentially replaced the 90% test contained in SSAP 21, hence more judgement will be needed on the part of the accountant.

The three additional indicators of situations that could also lead to classification of a lease as a finance lease are as follows:

• If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee
• Gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee (e.g. in the form of a rent rebate equalling most of the sales proceeds at the end of the lease)
• The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent

It is important to understand that the situations above are not exhaustive and this is reflected in the wording in paragraph 20.7 that confirms that all of the above situations are not always conclusive.  The key to determining the correct lease classification will all depend on whether the risks and rewards of ownership have transferred to the lessee or remain with the lessor at the inception of the lease. Paragraph 20.8 says that lease classification is made at the inception of the lease and the classification is not changed during the term of the lease (i.e. from operating to finance or vice versa) unless the lessee and the lessor agree to a change in the provisions of the lease (other than simply renewing the lease). Where such provisions are changed, the lease classification is then re-evaluated.

Determining the amounts in a finance lease

Once a lease has been determined as a finance lease, on initial recognition Section 20 would require a lessee to recognise its rights of use of that asset as an asset at an amount equivalent to the fair value of the leased asset or, if lower, the present value of the minimum lease payments which are determined at the start of the lease. Where a client incurs costs that are directly attributable in negotiating and arranging a lease, these costs are added to the amount recognised as an asset. 

Subsequent measurement: Finance leases

After initial recognition, paragraph 20.11 to FRS 102 requires a lessee to split the minimum lease payments between the capital element of the lease and the interest cost (as currently done in SSAP 21 and the FRSSE). However, the reduction in the outstanding liability is calculated using the effective interest method’. The effective interest method is a method of calculating the amortised cost of either a financial asset or a financial liability (or a group of financial assets and liabilities) and therefore allocating the interest component of the lease payments over the relevant period. Under the effective interest method:

• The amortised cost of the finance lease liability is the present value of future payments discounted at the effective interest rate
• The interest expense in a period is equivalent to the carrying amount of the liability at the beginning of a period multiplied by the effective interest rate for the period

For the purposes of this calculation, the effective interest rate is the rate that exactly discounts the future payments through the expected life of the lease. The effective interest method will be discussed in more detail in a future article concerning financial instruments. 

In addition, the lessee must depreciate the leased asset over the shorter of the lease term and its useful economic life and at the end of each reporting period assess whether an asset leased under a finance lease is impaired. There is no change to how we depreciate such assets under SSAP 21.

Operating leases

These will essentially follow the same accounting treatment as SSAP 21 which is that the lessee will recognise payments under operating leases (excluding costs for services such as insurance and maintenance) as an expense over the lease term on a straight-line basis, unless:

• Another systematic basis is representative of the time pattern of the user’s benefit, even if the payments are not on that basis
• The payments to the lessor are structured to increase in line with expected general inflation (based on published indexes or statistics) to compensate for the lessor’s expected inflationary cost increases. However, if payments to the lessor vary because of factors other than general inflation, then this condition is not met

If a lessee receives a lease incentive, this is accounted for as a reduction to the expense over the lease term on a straight-line basis, unless another systematic basis is representative of the time pattern of the lessee’s benefit from the use of the leased asset. 

Lessor accounting: Finance leases

Lessors recognise assets that are subject to finance leases in their balance sheet (statement of financial position) as a receivable (a debtor) at an amount that is equal to the net investment in the lease (which is the gross investment in the lease, but discounted at the interest rate implicit in the lease). The gross investment is the total of:

• The minimum lease payments receivable by the lessor under the finance lease
• Any unguaranteed residual value accruing to the lessor

Finance income is recognised in profit or loss based on a pattern that reflects a constant periodic rate of return on the lessor’s net investment in the finance lease. 

Manufacturer or dealer lessors

Where lessors are manufacturers or dealers, a finance lease can give rise to two types of income:

• A profit or loss resulting from outright sale of the asset
• Finance income over the period of the lease

Revenue recognised at the outset of a lease by a manufacturer or dealer lessor is the fair value of the asset. However, if the present value of the minimum lease payments accruing to the lessor (calculated using the market rate of interest) is lower than the fair value of the asset, this is used as the revenue figure.

The cost of sale recognised at the outset of a lease is the cost (or carrying amount if different) of the leased asset less the present value of the unguaranteed residual value. 

The difference between the revenue and the cost of sale is clearly the selling profit. However, where a manufacturer or dealer lessor enters into an operating lease, it will not recognise any profit on sale because it is not the equivalent of a sale. 

Lessor accounting: Operating leases

Assets which are subject to operating leases are recognised in the lessor’s balance sheet (statement of financial position) depending on the nature of the asset and income arising from the lease is recognised in the lessor’s profit and loss account on a straight-line basis over the life of the lease.  There are two exceptions to the straight-line basis of income recognition, which apply to when:

• Another systematic basis is representative of the time pattern of the lessee’s benefit from the leased asset, even if the receipt of payments is not on that basis
• The payments to the lessor are structured to increase in line with expected general inflation (based on published indexes or statistics) to compensate for the lessor’s expected inflationary cost increases. If payments to the lessor vary according to factors other than inflation, then this condition is not met

Costs associated with operating leases from the standpoint of the lessor are dealt with as follows:

Cost of lease incentives

These are recognised as a reduction to the income recognised over the lease term on a straight-line basis unless another systematic basis is representative of the time pattern over which the lessor’s benefit from the leased asset is diminished.

Costs

Costs incurred with earning the lease income (paragraph 20.26 cites depreciation as such a cost) are recognised as expenses and the depreciation policy of such assets will be consistent with the lessor’s normal depreciation policy for similar assets.

Incidental costs of negotiating and arranging the operating lease

These are added to the cost of the leased asset and recognised as an expense in profit or loss over the lease term on the same basis as the lease income.

Disclosures: Finance leases (lessee’s financial statements)

Paragraph 20.13 says that a lessee shall make the following disclosures for finance leases:

• For each class of asset, the net carrying amount at the end of the reporting period
• The total of future minimum lease payments at the end of the reporting period, for each of the following periods:
• not later than one year
• later than one year and not later than five years
• later than five years
• A general description of the lessee’s significant leasing arrangements including, for example, information about contingent rent, renewal or purchase options and escalation clauses, subleases, and restrictions imposed by lease arrangements 

Also, the requirements for disclosure concerning assets in accordance with Section 17 Property, Plant and Equipment and Section 27 Impairment of Assets also apply to lessees for assets leased under finance leases.

Disclosures: Operating leases (lessee’s financial statements)

Paragraph 20.16 requires the following disclosures for operating leases:

• The total of future minimum lease payments under non-cancellable operating leases for each of the following periods:
• not later than one year
• later than one year and not later than five years
• later than five years
• Lease payments recognised as an expense

Disclosures: Finance leases (lessor’s financial statements)

Paragraph 20.23 requires the following disclosures for finance leases in a lessor’s financial statements:

• A reconciliation between the gross investment in the lease at the end of the reporting period, and the present value of minimum lease payments receivable at the end of the reporting period.  In addition, a lessor shall disclose the gross investment in the lease and the present value of minimum lease payments receivable at the end of the reporting period, for each of the following periods:
• not later than one year
• later than one year and not later than five years
• later than five years
• Unearned finance income
• The unguaranteed residual values accruing to the benefit of the lessor
• The accumulated allowance for uncollectible minimum lease payments receivable
• Contingent rents recognised as income in the period
• A general description of the lessor’s significant leasing arrangements, including, for example, information about contingent rent, renewal or purchase options and escalation clauses, subleases, and restrictions imposed by lease arrangements

Disclosures: Operating leases (lessor’s financial statements)

Paragraph 20.30 requires the following disclosures for operating leases in the lessor’s financial statements:

• The future minimum lease payments under non-cancellable operating leases for each of the following periods:
• not later than one year
• later than one year and not later than five years
• later than five years
• Total contingent rents recognised as income
• A general description of the lessor’s significant leasing arrangements, including, for example, information about contingent rent, renewal or purchase options and escalation clauses, and restrictions imposed by lease arrangements

In addition, paragraph 20.31 requires disclosures about assets in accordance with Section 17 Property, Plant and Equipment and Section 27 Impairment of Assets for assets provided under operating leases.

Leasing: The future?

The IASB is planning to revise the way that leases are accounted for. In a nutshell, the vast majority of leases (those with terms longer than 12 months) will all fall to be classed as finance leases with only a minority of leases being classified as operating leases. The objective here is to combat the problem of off-balance sheet finance and these proposals have certainly not been without controversy. The IASB has said that, despite the risks and rewards of ownership (which currently decipher whether a lease is finance or operating), it is the ‘rights of use’ that should determine lease classification. The IASB has looked at lease classification in the context of the Conceptual Framework for Financial Statements and concluded that an asset subject to an operating will meet the definition of an asset because the lessee has the right to use the asset and enjoy economic benefits generated from that use. On the flip side it also meets the definition of a liability because the lessee has obligations to pay the lessor lease rentals, hence should appear on the face of the balance sheet. 

These proposals are very controversial at present and are likely to affect retailers, airlines and transport companies who all make most use of operating leases. 

They are due to be redeliberated in the final quarter of 2013 before the IASB decide on whether to issue a new standard in 2014. 

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘Interpretation and Application of International Standards on Auditing’.