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What balance sheet entries are required when setting up and during the life of a finance lease?

What balance sheet entries are required when...

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My client has recently raised £30k from a finance company who have entered into a leasing arrangement over the client company's existing plant and machinery, with 36 monthly payments required after which the assets will revert back to the company. The accompanying documents describe this as a finance lease and says that the monthly lease payments are fully tax deductible.

Are we required to continue to show these historic machine assets on the balance sheet from now on together with an outstanding lease liability?  If so, how does the lease liability reduce over time if the monthly payments are put through the accounts as revenue expenditure?  Is the starting liability the £30k or the value of the monthly payments x 36?

Finally, the £30k exceeds the written down value of the assets currently in the balance sheet.  How do we account for this surplus?

Any help gratefully received.

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By BKD
02nd Nov 2012 14:05

Clarify, please

What exactly are the arrangements? If the company already owns the plant, how can it lease it as well? Or are you saying that there is a sale and leaseback, with the company re-purchasing the plant at the end of the lease? If so, what is the purchase price to be paid at the end of the lease?

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By Springfield
02nd Nov 2012 14:47

Thanks

Yes, I believe it must be a sale & leaseback although this is not explicitly stated in any documentation.  The plant will revert back after three years for a "nominal" final sum.

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By BKD
02nd Nov 2012 15:05

Sounds to me, then ...

... that it is not a finance lease, but a hire (or lease) purchase agreement.

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By Brend201
07th Nov 2012 12:00

I think it is a finance lease.  SSAP 21 (or whatever is current) applies.  The substance of the transactions take precedence, for accounting purposes, over the strict legal form of the contract. 

The accounting entries (and since it has been a while since I set up a lease, I might be a bit rusty):

Sale of assets to lessor - record a disposal and a gain on disposal.  

Set up of new finance lease - debit fixed assets at cost of £30,000; credit finance lease liability in the balance sheet £30,000.

Set up a depreciation schedule for the £30k assets - might not be appropriate to depreciate them over longer than the 36 months, but you might check that with your auditors.  Have a look at your accounting policies too.

The finance lease liability will be reduced over the period of the repayments.  Example: The repayments, I presume, will come to, say, 36 x £900, giving an overall total of £32,400.  That £2,400 represents the interest cost/finance charge payable over the period of the primary lease period, 36 months.  Each repayment consists of a capital repayment element and an interest element.  The interest element should be apportioned over the 36 payments on an appropriate basis (straight line not really appropriate) - sum of the digits or similar would be ok.  

Thus, for example, the first repayment would be split between e.g. interest £150 and capital repayment £750 and the last repayment would be interest £50 and capital repayment £850.  

At the end of the 36 months, the lease liability balance is nil.  

Then secondary lease rentals usually kick in indefinitely unless you exercise your right to buy the asset from the leasing company.  

I can't remember the tax treatment of the rentals or of the end of lease repurchase but your tax adviser will be able to give guidance.  

 

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By Paul Cleverley
07th Nov 2012 12:01

My take

 

My client has recently raised £30k from a finance company who have entered into a leasing arrangement over the client company's existing plant and machinery, with 36 monthly payments required after which the assets will revert back to the company. - The lease company now owns the assets, write them down to zero in the balance sheet and take a profit (or loss) in the P&L against what the finance company has paid for them.

Are we required to continue to show these historic machine assets on the balance sheet from now on together with an outstanding lease liability? - The lease is shown as a liability then written down by the capital portion of the repayment every month. The interest is charged to the P&L.

Is the starting liability the £30k - YES or the value of the monthly payments x 36? - NO

Finally, the £30k exceeds the written down value of the assets currently in the balance sheet.  How do we account for this surplus? - See my first solution.

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By thegable
07th Nov 2012 12:56

Lease payments

If the lease company says the payments are fully tax deducable then they should be expensed through P+L as they are paid (and no doubt will  have VAT added). Therefore I would sell the assets to the finance Co for £1 and report a book loss. When the agreement finishes write off the notional final payment also to lease costs. As the agreement proceeds, record the ongoing liability in the annual accounts as a note.

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By Paul Cleverley
07th Nov 2012 13:02

Only the interest portion will be deductible, and VAT doesn't even come in to the P&L ' cos you're just HMRC's agent to collect any pay this.

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By pauljenkinsandco
07th Nov 2012 13:05

Tax Treatment??

Finance company says that the payments will be 100% deductible? As if it is a rental agreement.

Is that correct if the asset is being capitalised?

And if the payments are 100% deductible then of course there will be no capital allowance.

So the P&L account will show depreciation and interest - and these will be added back in the tax computation and the actual repayments will be deducted.

That's how I read what is being said. Am I correct --- and is this treatment correct? Tax specialists expertise needed here please.

I must admit that I would have treated the whole thing as a hire agreement on the basis that the final payment to repurchase the plant at the end of the lease is one which the client presumably is not committed to (or are they?). I'd have treated it as a hire agreement until the final (voluntary!) payment is made and then the final payment is a separate purchase of assets attracting Capital allowances.

Presumable I'd have been way off the mark????

 

 

 

 

 

 

 

 

 

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By pauljenkinsandco
07th Nov 2012 13:06

looks like thegable and I are of the same opinion

Looks like I;m with thegable on this one --- but I'm certainly open to being corrected by the experts!

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By Paul Cleverley
07th Nov 2012 13:34

Payments Lease / rental v.s. loan

Lease / rental - no balance sheet entry

Loan - interest to P&L, capital to liability.

Either way assets are written down and profit or loss recorded in P&L when finance company acquires them.

At the end of the agreement, either buy back from finance company or return to finance company.

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By AdShawBPR
07th Nov 2012 13:53

This sounds like an HP agreement

If there is a nominal/bargain purchase option at the end of the 3 year term, that means the Seller/'Hire purchasee' (Seller) will almost certainly exercise that option and ownership will revert to the Seller.  This is a hire purchase agreement as defined in SSAP21.  In a finance lease, there is no such option to purchase for the lessee.  The interest element of the repayments (not rentals) on what is basically a loan, will be tax deductible, and the asset will remain on the books as such and should be depreciated as before.  I don't see the 36 month term as being relevant for the depreciation as full ownership is certain to revert.

I'm not entirely clear about the capital allowance treatment here - there has been a sale and, for tax purposes, a purchase for the same amount so should be neutral.  Perhaps not though if this was being held in a short life asset pool.

Assuming the Seller is VAT registered, there should I think be VAT on both the sale and the HP back, but cash wise this should wash out.  There would be no VAT on the HP repayments, in the same way as there is no VAT on  loan repayments.  (VAT is chargeable on lease rentals as this is a supply of goods over time.)

Just because the documents say it's a finance lease doesn't necessarily make it so but, if that is what they say, either the facts are not quite as stated or the documents are wrong.

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By AdShawBPR
07th Nov 2012 13:59

Treat lease repayments as a loan....

On your last quastion, assuming this is indeed a hire purchase agreement, the repayments do not go through the P&L as rentals.  You would write down the HP obligation by the capital element of the HP repayments in exactly the same way as if this had been a loan.

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By thegable
07th Nov 2012 14:09

Rental payments

To clarify..it appears the payments each month are effectively for hiring/renting the equipment thus allowing immediate expensing through P+L. This will be confirmed when you note that the monthly charges have VAT added.

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By mikanary
07th Nov 2012 14:29

Can't be a finance lease

On the facts as originally stated, if the agreement permits the lessee (OP's client) to purchase at the end of the initial term this cannot be a finance lease, whatever the paperwork might say.  It must be HP.

The regular payments for a finance lease would carry input VAT, for an HP agreement there would only be input VAT included within, generally, the deposit.  So it should be easy to identify.

In either case to comply with UK GAAP the asset and liability must be disclosed on the balance sheet.

Interest gets relieved in the P&L in either case.  For HP assets capital allowances will be due subject to usual rules, but I would suggest no AIA as this is the re-purchase of pre-owned assets. (BTW balancing charge on original disposal).

For leased assets the capital payments get relieved "at the same rate as normal commercial depreciation" on the asset. 

Simples

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By petestar1969
07th Nov 2012 15:22

ERR

Aren't finance lease and hire purchase agreements one and the same thing?

Surely the distinction is between an operating lease (rental through P&L) and finance lease/HP where you recognise the asset and associated liability and take the finance charges/HP interest to P&L?

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Replying to johngroganjga:
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By mikanary
07th Nov 2012 15:50

No Err

petestar1969 wrote:

Aren't finance lease and hire purchase agreements one and the same thing?

Surely the distinction is between an operating lease (rental through P&L) and finance lease/HP where you recognise the asset and associated liability and take the finance charges/HP interest to P&L?

No.

Although the accounting treatment as specified under SSAP21 may appear to be the same for HP and leased assets the form of the finance lease agreement does not permit ownership to pass to the lessee at the end of the lease term and therein lies the difference between them.  As I indicated in my earlier post the application of input VAT will show which particular type of finance agreement this is and the OP should be able to confirm how it is being charged in this case.

Essentially the leasing/finance company gets the initial capital allowances if it is a finance lease, the lessee does not.  If it is HP the purchaser (in this case client/lessee) does.

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By Param
07th Nov 2012 18:37

Revalued at £30,000.00 by

Revalued at £30,000.00 by leaseing company.

Dispose the assets.

Work out the profit or loss on the disposal

Bring back at £30,000.00

Depreciate as normal @ 25% reducing balance method.

Repayments set off against the creditor. (30k + interest)

Interest element to be charged to the P & L as per the number of repayments.

 

 

Param

P/Q Accountant

 

 

 

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Replying to Ruddles:
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By Param
07th Nov 2012 18:42

this a HP approach

if a lesing approach is taken, then assets will be disposed and the payment net of VAT will be taken as hire of equipment.

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By masont
07th Nov 2012 19:30

international standards

The guidance that I have used in previous roles with lease transactions is that if a particular lease meets any of the following criteria, it is a finance lease:

a) the lease transfers ownership of the property to the lessee at the end of the lease term, or

b) the lease contains an option to purchase leased property at a bargain price, or

c) lease term is equal to 75% or more of the estimated economic life of the leased property, or

d) the present value of rental and minimum lease payments equals or exceeds 90% of the fair value of the leased property.

it would seem in this case that at least a & d (and possibly b or c) identify this as a finance lease.

In addition, it is likely that the lessee has substantially all the risks and rewards of owning the asset, and there is also likely to be the expectation that any nominal final payment will be made to acquire the asset.

Under IAS17 (leases) the lessee should recognise the finance lease as an asset (30,000) and a liability (value of minimum lease payments).

Any profit in the sale and leaseback of the asset should be recognised and amortised over the lease term, not taken 100% at the inception of the lease.

The depreciation policy for leased assets should be the same as for owned, and the depreciation calculated in accordance with IAS16 Property, Plant & Equipment.

The asset would only be depreciated over the life of the lease if there was no reasonable certainty that the lessee will obtain ownership at the end of the lease term.

lease payments should be apportioned with the liability reduced by the capital element, and the interest element being reported on the P&L.

Hope this helps.

 

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By La BoIS Saint
08th Nov 2012 07:48

My four penn'orth

 

Amazing how so many people can have so many different ideas! A bit worrying really.

I have never known anything to cause so much confusion as HP v finance lease. I think it is because SSAP21 says to treat them the same even though they are different legally.

Point 1. Ignore anything the company selling this arrangement says. They have a vested interest in trying to persuade you of an advantageous tax treatment and you could hardly rely on them if it was queried by HMRC. Of course if you can get a guarantee from them that they would back up with cash it might be a different matter.

Point 2. From a purely substance over form point of view is this anything other than a loan with the assets held as security? I would be uncomfortable with recognising a gain on the sale of the assets when in reality nothing has changed. Is it even possible the finance company would remove the assets? If you take the view that the assets should be revalued then under FRS15? (sorry books not to hand) all other assets in the same class should be revalued.

From the info in the original post this is definitely not a finance lease, the whole point of a FL being that ownership stays with the leasing company.

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By Springfield
08th Nov 2012 13:22

Thanks to everyone who has responded on this - all comments are greatly appreciated.

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By bcross
08th Nov 2012 16:50

FRS5

Lots of responses and must confess to only having a brief glimpse so apologies if anybody has already said this.

I think this is an FRS5 issue and we may be somewhat overcomplicating matters.

The substance of the transaction seems to be that a finance co has lent £30k against some assets and this is being paid off over 3 years.

The OP advises that the NBV of the assets is less than £30k. In my experience it is unlikely that a finance house would lend solely on assets if they thought they weren't worth considerably more. Is there any other security - PGs? Notwithstanding there may be an issue with a depn policy which is too conservative and this can be corrected going forward and by creating a reval reserve if so wished.

The nominal sum at the end of the agreement is key. It suggests that you will have paid for the assets over the lease in which case you are highly likely to pay the sum to regain legal title at the end of the 3 year period. Lets face it the plant will be the same just with a bit more wear and tear.

I think you create the creditor for £30k and as each payment is made the £30k is reduced and a proportion (interets and charges) is taken to P&L.

Wouldnt wish to comment on the tax treatment but the OP doesn't seem to be asking that in any case.

 

 

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