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Finance or Operating lease? Residential property

Should I be treating a 25 year lease for residential flats as a finance or operating lease?

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I have a client who very recently (and without giving me any notice) signed three 25 year leases for blocks of self-contained residential flats which my client rents out. I initially have gone down the Finance lease route, given the length of the lease term and as the 'risks and rewards of ownership' passes to my client for the lease term. Also my client must register the leases with the land registry and pay stamp duty on the leases. Having crunched the numbers as finance leases, it creates a £5.6m asset and liability, which is to be wound down over the 25 year lease term. This is very significant increase for this business (micro entity), which at it's last year end only had total assets of c£10k. 

I have checked the balance sheet of some of my client's competitors and they have treated these 25 year leases as operating leases. This has questioned my own approach. I feel like treating it as a finance lease artificially inflates the balance sheet and, given the way the numbers work, at the next year end the lease liabiltiy will be c£200k greater than the lease asset. Here is some examples of the finance lease criteria that has not been met:

  1. the lessor does not transfer ownership of the asset to the lessee at the end of the lease term
  2. gains or losses from fluctuations in the fair value of the residual fall to the lessee
  3. the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent
  4. the lease term is for the major part of the economic life of the asset (debatble)

The criteria that has been met includes: 

  1. 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
  2. property title is transferred on land registry (this makes the decision feel like a no brainer).

Do you agree with my initial assumption that these leases should be treated as finance leases? Any opinions are welcome.

    Replies (13)

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    Hallerud at Easter
    By DJKL
    05th Aug 2020 22:46

    If under FRS102 are they not treated under section 16 " Investment Properties", see:

    20.1 This section applies to leases, except for:

    (c) measurement of property 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)

    Effectively under 16 you get very similar treatment,

    16.1 This section applies to investment property and property interests held by a lessee under an operating lease that are classified as investment property (see
    paragraph 16.3).

    16.1A This section does not apply to investment property rented to another group entity andtransferred to property, plant and equipment (see paragraph 16.4A).
    16.2 [Deleted]
    Classification
    16.3 A property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property using this section if, and only if, the property would otherwise meet the definition of an investment property and the lessee can measure the fair value of the property interest on an on-going basis. The Appendix to Section 2 Concepts and Pervasive Principles provides guidance on determining fair value. This classification alternative is available on a property-by-property basis.

    So rather than looking at finance lease/operating lease I think I would be reviewing investment property treatment

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    By paul.benny
    06th Aug 2020 08:03

    Agree with DJKL.

    It's an investment property, and therefore:
    a) Initially capitalise in the same way as a finance lease
    b) In subsequent years, fair value the leasehold interest.

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    Replying to paul.benny:
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    By Tax Dragon
    06th Aug 2020 08:18

    And c) add back any change in value in the tax comp.

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    By HPS2020
    06th Aug 2020 09:09

    Thank you for the quick replies.

    Having reviewed section 16, 16.3A does apply (as my client's company is a CIC and the flats will be used to house vulnerable people):

    16.3A Property held primarily for the provision of social benefits, eg social housing held by a public benefit entity, shall not be classified as investment property and shall be accounted for as property, plant and equipment in accordance with Section 17 Property, Plant and Equipment.

    So it looks like PPE treatment is the answer for the asset side and to depreciate straight line over the 25 year lease. However, using this approach, would the lease liability still need to be recognised? Or are lease payments going to flow directly to the P&L?

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    Replying to HPS2020:
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    By paul.benny
    06th Aug 2020 11:04

    If you don't recognise the liability, your balance sheet won't balance.

    Thanks (1)
    Replying to paul.benny:
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    By HPS2020
    06th Aug 2020 11:16

    Yeah, I didn't really think that through enough.

    Is there any argument to just treat the leases as operating leases and avoid the big assets and liabilities on the balance sheet? I don't see it personally, but my client is adamant that it must be possible given his competitors are doing it?

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    Replying to HPS2020:
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    By paul.benny
    06th Aug 2020 11:28

    I think not - although you can read FRS102 for yourself.

    I'm not sure what practical difference it makes. The accounts are more complicated but there's little additional information in the public domain as a result of being small rather than micro.

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    Replying to paul.benny:
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    By Tax Dragon
    06th Aug 2020 11:42

    And I'd've thought a CIC should not object to company information being in the public domain anyway. (In short, I too am missing the point of the question.)

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    Replying to Tax Dragon:
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    By HPS2020
    06th Aug 2020 13:12

    Thanks for the replies. The challenge comes as my client is trying to avoid the fees associated with transitioning the company from FRS105 to FRS102, especially as they plan to lease a further 3 properties in the next year. Hence why the operating lease options is preferable to them.

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    Replying to HPS2020:
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    By paul.benny
    06th Aug 2020 13:47

    Tightwad client. And how much do you plan on charging them anyway?

    If they're acquiring three more similar properties won't the aggregate rental income will take them above the threshold for FRS105?

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    Replying to paul.benny:
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    By HPS2020
    06th Aug 2020 14:38

    Exactly.

    Well I currently charge a fixed fee of £1,000 per year, which includes payroll, accounts and CT return. I was planning on increasing the annual fee to c£2-£2.5k per year to reflect the increase in work (more staff on payroll, increased number of transactions per month, lease accounting etc.). Still a very reasonable price given the scale of the work.

    The income with the additional 3 leased properties would still keep turnover below the FRS102 threshold (just) - but it is the company is inevitably heading in that direction either way.

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    By PandoraSleeps
    06th Aug 2020 18:31

    I would approach it like this.

    First, look at section 20 to determine whether you have an operating or finance lease. The criteria are given in 20.5 and 20.6, though 20.7 makes it clear this is not always conclusive. It is likely there will be some indicators in both directions in which case a decision is needed "on balance".

    It sounds to me like you have 20.5(a) Op lease, (b) Op lease, (c) Query but I am not sure that I would take 25 years to be "the major part" of the economic life, debatable (d) No idea of the numbers but the value of the freehold will be a lot more than a 25 year lease out of it, (e) Op lease. You will need to consider 20.6, but on balance from 20.5 I am thinking probably Op lease.

    I would also not ignore "industry practice" entirely.

    It is ultimately your client's decision and so if you are happy they have taken a reasonable view on the above, having gone through the criteria with them, it is up to them how they classify the lease. I am assuming you are not auditing and if issuing an accountant's report you would need to be happy the accounts are not misleading as a result, but if there is a judgement call or something could be argued either way that's up to the client.

    As far as section 16 goes for investment property, which is relevant given your client's use of the asset, all section 16.3 does is give you the option of treating an investment property operating lease as investment property on the balance sheet. I.e. if you conclude that you have an operating lease, this is an accounting policy choice.

    Thanks (1)
    Replying to PandoraSleeps:
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    By paul.benny
    07th Aug 2020 08:22

    In my view, you're misreading the standard
    20.4 "A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership"

    Under a normal lease, the lessee is entitlement to all rental income, must fund all maintenance, must insure, must continue to pay rent in almost all circumstances. We don't know much about the building itself but 25 years could easily be the useful economic life - it may well need substantial refurbishment by 2045.

    That looks to me like substantially all the risks and rewards of ownership are with the lessee.

    As the standard spells out, 20.5 and 20.6 are *indicators* of whether leases are finance or operating, not tests

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