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AccountingINDEX
Classification of leases for accounting purposes In the UK context it is important to understand that for accounting purposes leases are classified as either operating leases or finance leases, whereas for corporate tax purposes the important distinction is that between leases and hire purchase contracts (see below for a description of what is meant by a hire purchase contract). Hire purchase contracts and conditional sale contracts will generally be finance leases, but it is possible to have a hire purchase contract that is an operating lease for accounting purposes, e.g. a vehicle contract purchase agreement. For accounting purposes, leases are classified as either finance leases or operating leases. The classification criteria are similar to that in IAS 17. A finance lease is defined by the accounting standard SSAP 21 (Accounting for leases and hire purchase contracts) as a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. All other leases are operating leases. There is a presumption that such a transfer of risks and rewards occurs if the present value of the minimum lease payments amounts to substantially all (normally 90 percent or more) of the fair value of the leased asset. However, the classification is essentially a question of judgement and this ‘90 percent test’ can be rebutted. This requirement to account for leases in accordance with their substance, rather than simply applying numerical tests such as the ‘90 percent test’, has been reinforced by Financial Reporting Standard, FRS 5 (Reporting The Substance Of Transactions). The guidance in FRS 5, which covers transactions in general, is relevant to lease classification. Whilst the classification rules are the same for both the lessor and the lessee, an individual lease can be classified differently by each party. For example, if the lessor has little asset risk because it has obtained a residual value guarantee from a third party, the lease would be a finance lease from the lessor’s point of view but it may be an operating lease from the lessee’s point of view. Amounts due from lessees under finance leases should be recorded in the balance sheet as debtors at the amount of the net investment in the lease, after making provisions for items such as bad and doubtful rentals receivable. Income should be allocated so as to give a constant periodic rate of return on the lessor’s net cash investment. The net cash investment includes all relevant cash flows, including tax. In this respect, UK accounting differs to IAS 17 as the latter prohibits income recognition methods that take account of tax. An asset held for use in operating leases should be recorded as a fixed asset and depreciated over its useful life. In certain circumstances, annuity, after tax and/or other interest methods of depreciation can be used. The rental income should generally be recognised on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which the benefit of the leased asset is receivable. Where an asset’s use has been obtained under a finance lease, it should be capitalised, ie, the lease should be recorded in the balance sheet as a fixed asset and as an obligation to pay rentals. Initially the value of the asset and liability should be the present value of the minimum lease payments that normally approximates to the asset’s fair value. The asset is then depreciated in the same way as for any fixed asset and the finance charges on the liability are allocated to accounting periods so as to give a constant periodic rate of charge on the remaining liability. Under present rules operating leases are not capitalised and the rentals should generally be charged on a straight-line basis over the lease term. In 1996, the International Accounting Standards Committee and the Accounting Standards Boards of five countries (collectively “G4+1”) jointly released a discussion paper suggesting, amongst other things, that the value of the lessee’s interest in all leased assets should be brought on to lessees’ balance sheets together with the liabilities attaching to the leases themselves. The UK Accounting Standards Board issued a paper in December 1999 on behalf of the G4+1 bodies setting out proposals for implementing this discussion paper. There remain a number of practical issues and it is not clear when such changes might come into effect. In a sale and leaseback, the leaseback is classified as for any other lease. If the leaseback is a finance lease, no sale of the asset is recognised for accounting purposes and no profit or loss arises on the ‘sale’. Instead, the transaction is accounted for as the raising of finance secured on the asset. The asset remains unchanged following the transaction and continues to be depreciated as before. If the leaseback is an operating lease, the sale of the asset is recognised and the asset is taken off balance sheet. The treatment of any apparent profit or loss on the sale is as follows:
There are no special rules relating to back and front loaded leases. If the lease is a finance lease, the timing of the rentals simply affects the rate at which the lessor’s investment in the lease and/or the lessee’s lease obligations decline. If the lease is an operating lease, the rentals are generally recognised on a straight line basis, even if the payments are not made on such a basis, unless another systematic and rational basis is more representative of the time pattern in which the benefit from the leased asset is receivable. The treatment of defeasance deposits is complex and depends on the extent to which there is a legal right of set off. For example, if a lessee deposits cash with a defeasance bank but the lessee is not released from its obligations under the lease, the deposit and lease obligations would remain on its balance sheet. In the case of a lessor under a finance lease, if a company in the lessor group receives a deposit and the criteria for offset are met, the lease receivables and deposit would, on consolidation, be treated as a single asset (or liability) for the net amount. In the case of an operating lease, the defeasance amount would, depending on the right of set off, either be treated as a deposit or as a prepaid rental.
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Saturday, February 4, 2012