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How lease accounting may look under FRS102 | accountingweb
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How lease accounting may look under FRS 102

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The proposal to put leasing transactions for lessees on the balance sheet has generated much debate. Steven Collings takes a look at the proposals contained in FRED 82.

6th Apr 2023
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The proposals for lease accounting contained in FRED 82, which was issued at the end of last year by the Financial Reporting Council (FRC), are significant. However, the comment period is open until 30 April 2023 so there is still time to submit feedback. 

FRED 82 Draft amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and other FRSs – Periodic Review was issued on 15 December 2022. One area that has generated a lot of debate is the proposal to put leasing transactions for lessees on the balance sheet. This new accounting treatment is only proposed for FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland. FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime is unaffected by the lease accounting proposals in FRED 82 and will continue to distinguish between a finance lease and an operating lease based on the risks and rewards approach.

Exceptions to on-balance sheet lease accounting

There are exceptions proposed for short-term leases and leases of assets of low value. A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less. The value of a low-value asset is based on its value at the start of the lease. However, the FRC has not proposed a benchmark monetary amount.

In the Basis for Conclusions of IFRS® 16 Leases, paragraph BC100 states that the IASB® had in mind leases of underlying assets with a value, when new, in the order of magnitude of US$5,000 or less (it should be noted that this monetary amount is not in IFRS 16 itself). 

Draft paragraph 20.9 in FRED 82 states that the assessment of the value of an underlying asset is based on the asset’s value at the commencement of the lease (this is one of the simplifications the FRC has included in developing the proposed accounting treatment). In contrast, IFRS 16, para B3 states that the assessment is based on the asset’s value when new. 

To aid preparers, the FRC has provided a list of examples of underlying assets that would, and would not, typically be of low value in draft paragraphs 20.11 and 20.12 as follows.

Assets that would typically be of low value (see draft para 20.11) Assets that would NOT be of low value (see draft para 20.12)
  • Tablet computers
  • Personal computers
  • Home printers and photocopiers
  • Mobile phones
  • Desk phones
  • Televisions
  • Small items of furniture
  • Portable power tools
  • Cars, vans, trucks and lorries
  • Cranes, excavators, loaders and bulldozers
  • Telehandlers and forklifts
  • Tractors, harvesters and related attachments
  • Boats and ships
  • Aircraft
  • Land and buildings

Illustrative accounting treatment

The example below illustrates how the accounting treatment might work under the proposals. It is based on some of the principles contained in IFRS 16, which may apply in FRS 102 if the periodic review amendments are finalised as drafted.

On 1 January 2025, Sunnie Ltd enters into a contract to lease an item of machinery for three years. The lessor agrees to maintain the machine during the lease term. The total contract cost is £210,000 and Sunnie will pay £5,833 per month (or £70,000 per annum). Sunnie accounts for non-lease components separately from lease components (see note to Step 1 below).If contracted separately, it has been determined that the standalone price for the lease of the machine is £190,000 and the standalone price for the maintenance element is £48,000.

If Sunnie were to go to its bank for an equivalent borrowing, the bank would charge an interest rate of 4%.

Step 1: Allocation of the payments

The annual payments of £70,000 are allocated between the lease and non-lease components of the contract based on their standalone selling prices as follows:

  • lease element: (£190k/£190k + £48k) x £70k = £56,000
  • maintenance: (£48k/£190k + £48k) x £70k = £14,000.

(Note draft, para 20.33 provides a practical expedient whereby a lessee may elect, by class of underlying asset, not to separate non-lease components from lease components. Instead, the lessee can account for each lease component, and any associated non-lease components, as a single lease component. Hence, if Sunnie did not have a policy of separating lease and non-lease components, the entire £70,000 would be recorded as lease payments.)

Step 2: Calculate the value of the right-of-use asset and lease liability

The lease liability is calculated as the present value of the minimum lease payments as follows.

Date Cashflow Discount rate Present value
  £   £
31.12.2025 56,000 1 / 1.04 53,846
31.12.2026 56,000 1 / 1.042 51,775
31.12.2027 56,000 1 / 1.043 49,784
      155,405
       
There are no directly attributable costs associated with the right-of-use asset (for example, legal fees). If there were, these would be included in the cost of the asset itself. The entries to record this transaction are as follows.
      £
Dr Right-of-use asset (balance sheet) 155,405
Cr Lease liability    155,405
Being initial recognition of right-of-use asset

The lease liability would then be accounted for using the amortised cost method in FRS 102, Section 11 Basic Financial Instruments as follows.

Year Opening balance Cashflow Interest (4%) Closing balance
  £ £ £ £
2025 155,405 (56,000) 6,216 105,621
2026 105,621 (56,000) 4,225 53,846
2027 53,846 (56,000) 2,154 -
 
In year 1     £
Dr Lease liability    56,000
Cr Cash at bank    56,000
Being payments to lessor    
       
Dr Interest expense (P&L)   6,216
Cr Lease liability    6,216
Being interest at 4%    
At the end of 2025, the lease liability of £105,621 will be split between its current portion of £51,775 (£105,621–£53,846) and its non-current portion of £53,846 to comply with the statutory formats of the balance sheet.

 

Step 3: Depreciate the right-of-use asset

The right-of-use asset is depreciated over its three-year lease term. This gives a depreciation charge of £51,802 (£155,405/3 years).

In the above example, as the lessor agrees to maintain the machine at its cost over the term of the lease, it could be argued that under FRS 102 (January 2022), the lease is an operating lease. Hence, lease rentals would simply be charged to profit or loss on a straight-line basis over the three-year lease term (unless another systematic basis would be more appropriate). Under the proposed lease accounting method, the lease rentals would not be charged to profit or loss and the impact can be seen as follows.

Impact on profit or loss as at 31 December 2025

FRS 102 (January 2022) FRS 102 proposals
  • Lease rental expense is £70,000
  • Maintenance cost is £14,000
  • Interest charge is £6,216
  • Depreciation is £51,802
  • Total expense is £72,018
     
Impact on the balance sheet as at 31 December 2025
FRS 102 (January 2022) FRS 102 proposals
  • No impact as the lease would be an operating lease 
  • Asset reported of £103,603
  • Liability reported of £105,621

You can see that the impact on profit or loss is negligible. However, there is a bigger impact on the balance sheet as the lessee is reporting an additional right-of-use asset with a net book value of £103,603 (£155,405 less depreciation of £51,802) and a corresponding lease liability of £105,621.

Tax effect of the above

HMRC is unlikely to issue guidance on the tax treatments of the above until such time that the proposals in FRED 82 are finalised. However, they did issue this Business Leasing Manual when IFRS 16 was finalised, which may give some indication as to the potential tax consequences of the above.

Have your say

The proposals for lease accounting are significant. It should be emphasised that the proposals contained in FRED 82 are not finalised and the comment period is open until 30 April 2023 so there is still time to submit your feedback to the FRC. All interested parties are encouraged to send in constructive feedback on the proposals by email to [email protected]

Following the comment period there could be further changes made to the on-balance sheet lease accounting proposals to reflect comments received by the FRC. 

Replies (8)

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By jon_griffey
11th Apr 2023 09:27

For many companies this is going to result in a massively inflated balance sheet and them crossing the audit threshold.

Thanks (8)
By jon_griffey
11th Apr 2023 09:27

For many companies this is going to result in a massively inflated balance sheet and them crossing the audit threshold.

Thanks (0)
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By tedbuck
13th Apr 2023 10:21

Yet another excursion into the fairy tale land of accounting standards - there used to be a standard that required truth and accuracy but that wasn't good enough for those who wanted accounts to be manipulated to show better than reality and accounts to be comparable so that the financial analysts job was easier. Basically keep the jobsworths happy, confuse the clients who can no longer understand the figures confuse the shareholders with so much information that it goes into the bin. (I had a set of accounts from a company (plc) which had nearly 200 pages - surely this is a 'confuse the shareholder' tactic - I cannot imagine any shareholder sitting down to read it through - I should think they would prefer the Beano.)
I shall be so glad to extricate myself from this profession and get back to reality but even that will be destroyed by governments trying to grab everyone's money to pay for the Civil Service and its grossly inflated salaries and pensions.

Thanks (2)
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By rjmannaca
13th Apr 2023 11:37

I was struggling to understand your discount rates and assumed I was seriously misunderstanding how to work out present value.

Then I looked at the results you had reached and realised it is a typo - you meant to put each year as a power and it simply added it to the number i.e. Yr1 - 1/1.04; Yr2 - 1/1.042; and Yr3 - 1/1.043. It should be Yr2 1/1.04 squared; Yr3 1/1.04 cubed.

I know this is an example but in practise should we also be required to adjust for the fact that the actual cash flow does not occur at the end of month 12 or is it acceptable to simply use this once a year calculation?

I assume that accounts prepared under FRS 102 A will also affected by this?

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By optimist
13th Apr 2023 12:20

What a waste of everyone's time

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By jon_griffey
13th Apr 2023 14:33

I really don't like this requirement to apply discounting. Firstly assuming a rate of 4% is a bit rum as it may well not be known to the client what rate the bank might have required.

So using the example given, the client has a cashflow lease liability of £56K x 3 = £168K which they will understand as that is what the liability is per the leasing agreement. But the accounts will show £155K. They and other users of the accounts like creditors and lenders will ask 'why is the figure £155K when the company owes £168K?

I really don't think this adds any benefit to the users of the accounts.

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Replying to jon_griffey:
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By rjmannaca
14th Apr 2023 11:29

It's easy enough to come up with a 'reasonable' estimated interest figure.

I do agree with you and especially for 'smaller' clients, this is of absolutely no practical benefit to anyone and adds nothing to the value of the accounts, no matter how "accurate" you try to be.

As to your point about client queries - how many clients really look at the accounts in that detail? Even if they do look and notice figures they don't understand, most assume it is correct and ignore it. If they ask and you tell them what it relates to - maybe a couple of clients might be interested to know how it is worked out, the rest prefer blissful ignorance.

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By Halex
16th Jun 2023 13:57

I can see this being straightforward in the type of example above .
But what happens with dilapidations provisions on leasehold property? Are these added to the cost of the the Right to Use Asset in the balance sheet and then depreciated? Or is it treated as a simple annual provision spread over the minimum lease term?

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