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Section 15 – Leases
Section 20 deals with the classification, initial recognition, subsequent measurement for finance and operating leases in addition to the disclosure requirements for each.
Scope of this section
Extract from FRS 105 – Section 15.1 – 15.4
15.1 This section covers accounting for all leases other than licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights (see Section 13 Intangible Assets other than Goodwill).
15.2 This section applies to agreements that transfer the right to use assets even though substantial services by the lessor may be called for in connection with the operation or maintenance of such assets. This section does not apply to agreements that are contracts for services that do not transfer the right to use assets from one contracting party to the other.
15.3 Some arrangements do not take the legal form of a lease but convey rights to use assets in return for payments. Examples of such arrangements may include outsourcing arrangements, telecommunication contracts that provide rights to capacity and take-or-pay contracts.
15.4 Determining whether an arrangement is, or contains, a lease shall be based on the substance of the arrangement.
OmniPro comment
In relation to points above, it is clear that where a property is leased to a third party under a finance lease, then it cannot be treated as an investment property on the basis that leasing an asset under a finance lease has no real difference to selling the asset.
In addition, contingent rents are specifically scoped into Section 15. Therefore, lease which incorporate terms stating that the rent payable for the asset will vary according to future sales or amount of future use or future prices indices or market rates would come within Section 15.
Agreements that transfer the right to use assets contain leases even if the lessor is obliged to provide substantial services in connection with the operation or maintenance of the assets.
In assessing whether an arrangement contains a lease, reporters should refer to Section 15.3 and 15.4 of FRS 105, the extracts from which are as per below:
Some arrangements do not take the legal form of a lease but convey rights to use assets in return for payments. Examples of arrangements in which one entity (the supplier) may convey a right to use an asset to another entity (the purchaser), often together with related services, may include outsourcing arrangements, telecommunication contracts that provide rights to capacity and take-or-pay contracts.
Determining whether an arrangement is, or contains, a lease shall be based on the substance of the arrangement and requires an assessment of whether: (a) fulfilment of the arrangement is dependent on the use of a specific asset or assets. Although a specific asset may be explicitly identified in an arrangement, it is not the subject of a lease if fulfilment of the arrangement is not dependent on the use of the specified asset. An asset is implicitly specified if, for example, the supplier owns or leases only one asset with which to fulfil the obligation and it is not economically feasible or practicable for the supplier to perform its obligation through the use of alternative assets; and (b) the arrangement conveys a right to use the asset. This will be the case where the arrangement conveys to the purchaser the right to control the use of the underlying asset.
In determining whether an arrangement exists, the key thing is to identify if a specific asset can be used to fulfil the arrangement. Certain features that may indicate that the purchaser (leasee) controls the assets are:
- The purchaser takes all, or all but an insignificant amount, of the output, unless the purchaser pays:
- The current market price per unit of product as of the time of delivery of the output;
OR
- A contractually fixed price per unit of output.
If the entity pays amounts that vary according to the specific terms of the arrangement between it and the supplier, this suggests that there may be a lease.
- The asset is on the purchaser’s premises or in another location where the purchaser has the ability or right to control physical access and how it is operated and has the right to an insignificant amount of the output. Where these two facts are present this is conclusive proof it contains a lease.
Classification of leases
Extract from FRS 105 – Section 15.5 – 15.9
15.5 A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.
15.6 Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:
a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
b) 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;
c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
d) at the inception of the lease the present value of the minimum lease payments
e) amounts to at least substantially all of the fair value of the leased asset; and
f) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.
15.7 Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are:
a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
b) gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee (eg in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and
c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
15.8 The examples and indicators in paragraphs 15.6 and 15.7 are not always conclusive. If it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership, the lease is classified as an operating lease. For example, this may be the case if ownership of the asset is transferred to the lessee at the end of the lease for a variable payment equal to the asset’s then fair value, or if there are contingent rents, as a result of which the lessee does not have substantially all risks and rewards incidental to ownership.
15.9 Lease classification is made at the inception of the lease and is not changed during the term of the lease unless the lessee and the lessor agree to change the provisions of the lease (other than simply by renewing the lease), in which case the lease classification shall be re- evaluated.
OmniPro comment
As can be seen, once a lease has been identified the point to be considered in determining whether it should be classed as a finance or operating lease is whether the risks and rewards of ownership transfer from the lessor to the lessee. The risks of ownership include the possibilities of losses from idle capacity, technological obsolescence and of variations in return because of changing economic conditions.
Rewards would include the expectation of profitable operations over the asset’s life, the gain from increase in capital value of the asset, or the right to sell the asset and realise the residual value.
Lease classification is made at the inception of the lease, which is the earlier of the date of the lease agreement or of a commitment by the parties to the principal provisions of the lease. Classification is not changed during the term unless the parties agree to a change in the provisions other than renewing the lease.
For operating leases, the significant element of the risk and rewards of ownership stays with the lessor. Therefore, an operating lease is usually for a period that is substantially less than the asset’s useful economic life, and the lessor will be relying on recovering a significant portion of his investment from either the proceeds from the asset’s sale or the asset’s further hire after the end of the lease term. The opposite is obviously the case where it is determined to be a finance lease.
The lease term in defined in FRS 105 glossary as the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with our without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. The standard does not specifically state what the major part of an assets life is so judgement is required in this instance but it would usually be expected to align with substantially all the risks and rewards of ownership transferring. Usually it will be a major part of the economic life where the lessor has included secondary period at a nominal rent (or substantially below market rates).
Computer equipment which is leased has a higher risk of obsolescence than other assets so although such an asset is capable of operating for a number of years, given the risk of obsolescence where it is leased for a shorter period than the operating life, it is likely this will be classed as a finance lease as the majority of the value of the asset is generated in the starting period of the lease.
When assessing the type of lease more importance is given to the terms of agreement that have a commercial effect in practice and look at the substance of the agreement rather than its legal form.
Title does not have to be transferred in order for it to be a finance lease. In practice where point b in Section 15.6 applies, then this is a key indicator of a finance lease. The point is that the price is set and it is going to be favorable for the lessee so in reality it is likely the lessee will take this option at the end of the lease. In contrast where the terms of the agreement stipulate that the lessee has an option to purchase the assets at a variable price equal to the asset’s fair value at the date of cessation, this would indicate that the lessor maintains the risks of changes in fair value and therefore would possibility indicate that a finance liability did not exist. In relation to the aforementioned points the opposite conclusion would be determined where the party to the contract was the lessor.
Section 15.6(d) above states that a finance lease exists where 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. This is a qualitative test. The standard does not state what is meant by the word ‘substantially’. Under Old GAAP, that standard specifically stated that where the present value of the minimum lease payments were 90% or more of the fair value of the asset, then this indicated the existence of a finance lease. Although this is not stated in Section 15, it would not be unreasonable for to use this 90% test in practice as such a percent would in itself indicate ‘substantially all’ of the fair value. That said, each case should be looked at on a case by case basis and take into consideration the other points mentioned in Section 15.6-15.7 above. See the application of this test in example 1 below.
In relation to point 15.7(b), where the lessee guarantees the residual value at the end of the lease or is obliged to purchase the asset at a pre-determined fixed price which equates to estimate market value at the cessation date or sell the asset in the market and reimburse the lessor for the shortfall between the sales price and the price guaranteed in the lease, then this would indicate the presence of a finance lease. Where put and call options are a feature of the lease, an assessment will have to be made to see if they are at predetermined prices or formula’s (thereby indicating a finance lease) or are they exercisable at the market price at the time the option is exercised thereby indicating an operating lease.
Example 1: Residual value guarantee
An entity leases a digger for 4 years to a customer. The value of the digger at the end of year 4 is estimated to be 35% of the original cost. Based on available market data, the likely range of residual values at the end of year 4 is between 30-45% of original cost. The leasee will guarantee any fall in value below 30% down to 20% of original cost. The lessor will guarantee the amount below 20%.
Given that the lessors exposure to the possibility of having to pay out any money is very remote, this is ignored in the determination, as a result the risks stay with the customer and the customer would more than likely classify this as a finance lease depending on other facts. The minimum lease payments would include the guaranteed minimum value of the digger that being 15% (35%-20%).
FRS 105 does not deal with situations where a lease has been classified as an operating or finance lease at inception and subsequently facts change. The general concepts of FRS 105 would require the substance of the transaction or arrangement to be looked at when assessing whether to change the classification of the lease at that time.
One way to treat this is to assume that a change in the lease terms since inception does not result in a change in classification other than in the following circumstances:
- The lessor and lessee agree to change the provisions of the lease (other than simply renewing the lease) during the term of the lease. Usually changes would be made to the duration of the lease or the number, amount or timing of lease payment. If this occurs the lease is re-evaluated as if it was a new lease to assess what type of lease it is as a result of the changes. The lease would be adjusted prospectively over the remaining lease term.
Note changes in estimates i.e. changes in the economic life or of the residual value or changes in circumstances (e.g. default by the lessee) do not result in a reclassification.
Example 2: Changes in lease classification
Company A enters into a 3 years lease on production equipment that has an economic life of 10 years. The entity has an option in the agreement to extend that lease for another 4 years at the market rate. At the inception, Company A did not believe the option would be exercised on inception so as a result treated it as an operating lease. In year 2, the company is almost certain it will extend. This is in effect a change in estimate. Even at this time where they are almost certain, the lease is not reclassified even where it would now be considered to be a finance lease.
Note as FRS 105 does not explicitly state how to treat this, an entity has a choice as to how this should be treated. The above is just an example of the way such an adjustment should be treated.
Initial recognition and subsequent measurement-financial statements of lessees: finance leases
Extract from FRS 105 – Section 15.10 – 15.13
Initial recognition
15.10 At the commencement of the lease term, a lessee shall recognise its rights of use and obligations under finance leases as assets and liabilities in its statement of financial position at amounts equal to the fair value of the leased asset or, if lower, the present value of the minimum lease payments, determined at the inception of the lease. Any initial direct costs of the lessee (incremental costs that are directly attributable to negotiating and arranging a lease) are added to the amount recognised as an asset.
15.11 The present value of the minimum lease payments shall be calculated using the interest rate implicit in the lease. If this cannot be determined, the lessee’s incremental borrowing rate shall be used.
Subsequent measurement
15.12 A lessee shall apportion minimum lease payments between the finance charge and the reduction of the outstanding liability. The lessee shall allocate the finance charge to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. A lessee shall charge contingent rents as expenses in the periods in which they are incurred.
15.13 A lessee shall depreciate an asset leased under a finance lease in accordance with Section 12 Property, Plant and Equipment and Investment Property. If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset shall be fully depreciated over the shorter of the lease term and its useful life. A lessee shall also assess at each reporting date whether an asset leased under a finance lease is impaired (see Section 22 Impairment of Assets).
OmniPro comment
The interest rate implicit in the lease is defined as the discount rate that at the inception of the lease causes the aggregate present value of:
(a) the minimum lease payments; and
(b) any further amounts guaranteed by third parties in respect of the asset’s residual value;
(c) the unguaranteed residual value to be equal to the sum of:
(i) the fair value of the leased asset;
AND
(ii) any initial direct costs of the lessor.
It is unlikely that enough detail will be given in the lease agreement for to obtain what the lessor believes the residual value, estimated life etc. is. This may mean the lessee will have to estimate this based on market conditions. As per above, where it cannot be determined an entity should use the rate it would cost to borrow similar funds over a similar term with similar security, the funds necessary to purchase the asset.
The minimum lease payments are defined by Section 15 as the payments over the lease term that the lessee is, or can be, required to make, excluding contingent rent, costs for services and taxes to be paid by the lessor together with any amounts guaranteed by the lessee or any party related to the lessee.
Where the lessee has an option to purchase the asset at a price which is very favorable (i.e. option price is very likely to be less than the fair value) and as a result it is very likely they will take the option then the cost of taking the option needs to be included in the calculation. If there is a penalty for not taking the option and the entity expects it will not take it, then this needs to be included in the present value calculation also.
Example 3: Accounting for finance leases – initial recognition and subsequent measurement– Lessee
Company A has purchased an asset under a lease arrangement. Details of the lease are as follows:
|
Fair Value of the Asset |
CU50,000 |
|
Five Annual Rentals Payable in Advance |
CU12,000 |
|
Estimate Residual Value on Disposal– Lessors Unguaranteed Amount |
CU5,000 |
|
Useful Life |
7 years |
The amounts the lessor is expected to receive from the future rentals, any guaranteed residual amounts is used to determine the interest rate implicit in the lease.
The implicit interest rate is the rate that exactly discounts the five rentals of CU12,000 plus the unguaranteed residual of CU5,000 at the end of the lease term for the lessor to the fair value of the asset of CU50,000 as detailed below. (Note if the lessee in this example was entitled to 10% of the residual, then the amount to be utilised in this calculation would be CU4,500 (CU5,000*90%)).This is a rate of 13.477%. This can be obtained through an excel based formula. The first table below shows the calculation performed to ascertain the rate implicit in the lease. The second table is the present value of the minimum lease payments plus the unguaranteed residual value of the lessor.
Table Illustration showing calculation of the interest rate implicit in the lease interest rate:
|
Year |
Opening Balance |
Cashflow |
Capital Element |
Interest for Period 13.477% |
Closing Balance |
|
|
|
|
|
|
|
|
1 |
50,000 |
(12,000) |
38,000 |
5,121 |
43,121 |
|
2 |
43,121 |
(12,000) |
31,121 |
4,194 |
35,315 |
|
3 |
35,315 |
(12,000) |
23,315 |
3,142 |
26,458 |
|
4 |
26,458 |
(12,000) |
14,458 |
1,948 |
16,406 |
|
5 |
16,406 |
(12,000) |
4,406 |
594 |
5,000 |
Table: Present value of the minimum lease payments plus the unguaranteed residual value of the lesser:
|
Period Ending |
Cashflows |
Formula to get PV factor |
Discount rate at 13.477% PV factor |
Present value of cash flow |
|
1 |
_ 12,000 |
1 |
1 |
_ 12,000 |
|
2 |
_ 12,000 |
1/(1.13477)^1 |
0.8812 |
_ 10,575 |
|
3 |
_ 12,000 |
1/(1.13477)^2 |
0.7766 |
_ 9,319 |
|
4 |
_ 12,000 |
1/(1.13477)^3 |
0.6843 |
_ 8,212 |
|
5 |
_ 12,000 |
1/(1.13477)^4 |
0.6034 |
_ 7,237 |
|
End of year 5 |
_ 5,000 |
1/(1.13477)^5 |
0.5314 |
_ 2,657 _______________ |
|
Total NPV |
|
|
|
_ 50,000 |
Therefore for capitalisation purposes the total amount to be capitalised in the lessees books is the present value of future payments excluding the present value of the residual value totaling CU2,657 above. i.e. amount to be capitalised is CU47,343 (CU50,000-CU2,657). As CU47,343/CU50,000 being the fair value of the asset = 94.6% this would suggest that substantially all the risks and rewards of ownerships have been transferred.
Therefore the journals required on initial recognition are:
|
|
CU |
CU |
|
Dr Fixed Assets |
47,343 |
|
|
Cr Finance Lease Liability |
|
47,343 |
Being journal to reflect liability for finance leased asset.
NOTE: the standard states that the lower of fair value of the asset or present value of minimum lease payments should be used. Therefore where the difference is material (may only be the case where some of the residual value risk lies with the lessor), the asset should be classified at the present value of the minimum lease payments. NOTE: if costs were charged by the lessor these would also be capitalised.
Usually in determining how the interest on the finance lease will be allocated in the leases books can be done on a sum of the digits method as illustrated as follows:
For this example each repayment is made yearly, hence there are 5 periods/repayments:
Total periods for the sum of the digits =5 + 4+3+2+1= 15
The CU12,657 (CU60,000-CU47,343) is then allocated over the 5 year period as per below (If the example above was on the monthly basis then total periods in this case was 60+59+58+57+56 etc.etc.)
|
Year |
Opening Balance |
Cashflow |
Capital Element |
Interest for Period |
Closing Balance |
|
|
|
|
|
|
|
|
1 |
47,343 |
(12,000) |
35,343 |
4,219 (5/15*CU12,657) |
39,562 |
|
2 |
39,562 |
(12,000) |
27,562 |
3,375 (4/15*CU12,657) |
30,937 |
|
3 |
30,937 |
(12,000) |
19,894 |
2,531 (3/15*CU12,657) |
21,468 |
|
4 |
21,468 |
(12,000) |
10,575 |
1,688 (2/15*CU12,657) |
11,156 |
|
5 |
11,156 |
(12,000) ___________ |
(844) |
844 (2/15*CU12,657) ___________ |
0 |
|
|
|
(60,000) |
|
12,657 |
The finance charge posted at the end of year 1 is CU4,219 and so on for subsequent years (Cr finance lease liability and Dr finance charge). While not mentioned in Section 15, under old GAAP the sum of the digits method was allowed. It would be still appropriate to use this method.
Alternatively, the effective interest method can be utilised to allocate the interest charge:
|
Year |
Opening Balance |
Cashflow |
Capital Element |
Interest for Period 13.477% |
Closing Balance |
|
|
|
|
|
|
|
|
1 |
47,343 |
(12,000) |
35,343 |
4,763 |
40,106 |
|
2 |
40,106 |
(12,000) |
28,106 |
3,788 |
31,894 |
|
3 |
31,894 |
(12,000) |
19,894 |
2,681 |
22,575 |
|
4 |
22,575 |
(12,000) |
10,575 |
1,425 |
12,000 |
|
5 |
12,000 |
(12,000) ___________ |
0 |
0 ___________ |
0 |
|
|
|
(60,000) |
|
12,657 |
From a fixed asset point of view the assets are depreciated over the shorter of their useful life or lease term. As the lease term is shorter this is depreciated over 5 years. Note if the entity could prove that it is likely that they will hold onto the asset after the lease term, then the 8 year period would be appropriate. We have assumed it will have no residual value from the point of view of the lessee as this will be received by the lessor (if there was then the residual value would be taken off the cost of the asset to get to the depreciable amount). The journals posted for fixed assets at each year end would be:
|
|
CU |
CU |
|
Dr Depreciation P&L |
9,469 |
|
|
Cr Accumulated Depreciation (CU47,343/5yrs) |
|
9,469 |
Contingent rents
Any contingent rents are expensed when incurred and is not capitalised on initial recognition. Example of where this applies is where a minimum amount of rental per period is payable and further rent may be payable based on turnover/excessive use. If the minimum amount is exceeded this cost is expensed as incurred.
Disclosures
For UK entities there are no disclosures required. However for ROI entities disclosure is required of the value included in creditors which are secured on assets in the balance sheet.
Example 3a: Finance lease disclosures – Leasee (ROI entities)
Included in creditors is an amount of €XX (2015: €XX) which relates to amounts payable on finance leases entered into which are secured on the related asset to which the finance lease relates.
Initial recognition and subsequent measurement – financial statements of lessees and lessor: operating leases
Financial statements of lessees: operating leases
Extract from FRS 105 – Section 15.14 – 15.17
Recognition and measurement
15.14 A lessee shall recognise lease 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.
15.15 A lessee shall recognise the aggregate benefit of lease incentives as a reduction to the expense recognised in accordance with paragraph 15.14 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. Any costs incurred by the lessee (for example costs for termination of a pre-existing lease, relocation or leasehold improvements) shall be accounted for in accordance with the applicable section.
15.16 Where an operating lease becomes an onerous contract a micro-entity shall also apply Section 16 Provisions and Contingencies.
Disclosure in the notes
15.17 A micro-entity shall determine the amount of any financial commitments, guarantees and contingencies not recognised in the statement of financial position arising from operating leases and disclose that amount within the total amount of financial commitments, guarantees and contingencies (see paragraph 6A.2).
OmniPro comment
The entity recognises an expense from the date when the lease commences rather than the inception date. Where for example, an entity has taken out a lease but the retailer is not ready to open, the standard requires that this cost be expensed during the period, it cannot be deferred on the balance sheet.
Where costs are incurred which are directly attributable to negotiating and arranging a lease, these should be capitalised and expensed over the life of the lease on a straight line basis. If it is not related to that lease then it is expensed. A termination penalty for an old premises so that the entity could move into a new premises cannot be capitalised as this is a separate transaction and is not an asset.
FRS 105 does not detail exact rules on how increases incorporated in the lease should be dealt with (e.g. general inflation increases). When deciding how to account for these, usually only lease increases specifically linked to a general inflationary index which is published can be expensed as incurred. If they do not then they are expensed on a straight line basis over the life of the lease.
Example 4: Operating lease with inflationary increases
X operates in a jurisdiction in which the consensus forecast by local banks is that the general price level index, as published by the government, will increase by an average of 10 per cent annually over the next five years. X leases some office space from Y for five years under an operating lease. The lease payments are structured to reflect the expected 10 per cent annual general inflation over the five-year term of the lease as follows:
|
Year 1 |
CU100,000 |
|
Year 2 |
CU110,000 |
|
Year 3 |
CU121,000 |
|
Year 4 |
CU133,000 |
|
Year 5 |
CU146,000 |
X recognises annual rent expense equal to the amounts owed to the lessor as shown above. If the escalating payments are not clearly structured to compensate the lessor for expected inflationary cost increases based on published indexes or statistics, then X recognises annual rent expense on a straight-line basis: CU122,000 each year (sum of the amounts payable under the lease divided by five years).
Example 4a: Operating lease with inflationary increases
Company A enters into a lease on a building for 5 years for an annual fee of CU20,000. Under the lease agreement rents will increase in line with the general increase/decrease in published inflation. However, it also stipulates that the minimum inflation rate that will be charged is 2% even where the published rate is lower. As the lease agreement is no longer linked to a general inflation rate and is capped, so therefore the amount that should be expensed each year is as follows:
CU20,000+(CU20,000*1.02) + (CU20,000*1.04)+ (CU20,000*1.06)+ (CU20,000*1.08)= Total cost over the 5 years = CU104,080 /5year = CU20,816
Anything above the CU20,816 in any year is expensed as incurred.
Lease incentives
It is not unusual for landlords to provide tenants with incentives to enter into a lease agreement, especially for land and buildings. In order to encourage a key tenant to take on a lease, landlords may offer a cash sum, a specific length of time rent free or provide a contribution towards the cost of fitting out the premises. Section 15 requires such incentives to be deferred and credited into the profit and loss account over the life of the lease.
Example 5: Rent free period
Company A entered into a lease with a landlord for 10 years with a rent review after year 5. The rent payable on the lease per annum is CU200,000. As part of the agreement, the landlord agreed to provide the first 3 months rent free (CU200,000/12mths*3mths=CU50,000). Under Section 15, the lease incentive needs to be written off over the life of the lease. Assume the lease agreement commenced on 1 October and Company A’s year end is 31 December. The journals required to be posted in Company A’s TB at the 31 December are
|
|
CU |
CU |
|
Dr Rental Expense in P&L (CU16,250* X 3 months) |
48,750 |
|
|
Cr Lease Incentive Accrual BS |
|
48,750 |
Being journal to recognise the expense for the first 3 months in year one
From year 2 on, the CU48,750 is written back to the profit and loss and set against the rental expense over the life of the lease i.e. at the end of year 2 the accrual would be reduced to CU43,750 (CU48,750-CU5,000) to show the net cost of CU195,000 per annum.
If in the above example the landlord provided a contribution of CU50,000 towards the cost of fixed assets or towards the cost of relocating, the treatment would be the same.
* Calculate the actual total rental payments over the 10 years i.e. actual rent payments are only paid for 9 years and 9 months = CU200,000 *9.75 years= CU1,950,000. Therefore the total amount of rent to be charged over the life of the lease is = CU1,950,000/10 years = CU195,000 per annum or CU16,250 per month. Therefore for the first 3 months an accrual is required as no payment is made. However, this accrual is then reduced over the life of the lease such that the cost shown each year is CU195,000. NOTE: the date of the rent review is ignored.
Disclosures
A company shall determine the amount of any financial commitments, guarantees and contingencies not recognised in the statement of financial position arising from operating leases and disclose that amount within the total amount of financial commitments, guarantees and contingencies. See example below:
Example 5a: Operating lease disclosure
At 31 December 2015, the company had commitments under non-cancellable operating leases of CUXXXXX.
Initial recognition and subsequent measurement – financial statements of lessor: operating leases
Financial statements of lessors: operating leases
Extract from FRS 105 – Section 15.24 – 15.29
Recognition and measurement
15.24 A lessor shall recognise lease income from operating leases (excluding amounts for services such as insurance and maintenance) in profit or loss on a straight-line basis over the lease term unless 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.
15.25 A lessor shall recognise the aggregate cost of lease incentives as a reduction to the income recognised in accordance with paragraph 15.24 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.
15.26 A lessor shall recognise as an expense, costs, including depreciation, incurred in earning the lease income. The depreciation policy for depreciable leased assets shall be consistent with the lessor’s normal depreciation policy for similar assets.
15.27 A lessor shall add to the carrying amount of the leased asset any initial direct costs it incurs in negotiating and arranging an operating lease and shall recognise such costs as an expense over the lease term on the same basis as the lease income.
15.28 To determine whether a leased asset has become impaired, a lessor shall apply Section 22.
15.29 A manufacturer or dealer lessor does not recognise any selling profit on entering into an operating lease because it is not the equivalent of a sale.
OmniPro comment
Accounting for operating leases by lessors is a mirror of the treatment for lessees. Therefore see comments above in relation to operating lease accounting for lessees.
Initial recognition and subsequent measurement – financial statements of lessor: operating leases
Extract from FRS 105 – Section 15.18 – 15.20
Initial recognition and measurement
15.18 A lessor shall recognise assets held under a finance lease in its statement of financial position and present them as a receivable at an amount equal to the net investment in the lease. The net investment in a lease is the lessor’s gross investment in the lease discounted at the interest rate implicit in the lease. The gross investment in the lease is the aggregate of:
a) the minimum lease payments receivable by the lessor under a finance lease; and
b) any unguaranteed residual value accruing to the lessor.
15.19 For finance leases other than those involving manufacturer or dealer lessors, initial direct costs (costs that are incremental and directly attributable to negotiating and arranging a lease) are included in the initial measurement of the finance lease receivable and reduce the amount of income recognised over the lease term.
Subsequent measurement
15.20 The recognition of finance income shall be based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease. Lease payments relating to the period, excluding costs for services, are applied against the gross investment in the lease to reduce both the principal and the unearned finance income. If there is an indication that the estimated unguaranteed residual value used in computing the lessor’s gross investment in the lease has changed significantly, the income allocation over the lease term is revised, and any reduction in respect of amounts accrued is recognised immediately in profit or loss.
OmniPro comment
The accounting calculations for the lessor and the thought process is almost a mirror to what it is for a lessee. The exception is in the determination and calculation of the minimum lease payments. For the lessor they must include the minimum lease payments to be received plus any residual value that has been guaranteed (whether by the lessee or someone related to them or a third party) in addition to the payments required to be made by the lessee. Note the sum of the digits basis can also be utilised.
Example 6: Finance lease accounting for the lessor
If we take example 3 and apply this from the perspective of the lessor this time as opposed to the lessee. Assume payments are made annually. Note if payments are made monthly then it would have to be completed on a monthly basis.
|
Year |
Opening Balance |
Rent Received |
Capital Element |
Financial Income for Period 13.477% |
Gross investment allocated at end of period |
Gross earning allocated to future periods |
Net investment at end of period |
|
|
|
|
|
|
|
|
|
|
1 |
50,000 |
12,000 |
38,000 |
5,121 |
53,000 |
9,879 |
43,121 |
|
2 |
43,121 |
12,000 |
31,121 |
4,194 |
41,000 |
5,685 |
35,315 |
|
3 |
35,315 |
12,000 |
23,315 |
3,142 |
29,000 |
2,542 |
26,458 |
|
4 |
26,458 |
12,000 |
14,458 |
1,948 |
17,000 |
594 |
16,406 |
|
5 |
16,406 |
12,000 _______ |
4,406 |
594 _______ |
5,000 |
– |
5,000 |
|
|
|
60,000 |
|
15,000 |
|
|
The CU15,000 represents the interest income earned over the life of the lease (i.e. the CU60,000 in rentals received over the life of the lease plus the expected residual value for which the lessor is entitled to of CU5,000). At any period end the net receivable balance is the unearned finance income plus the residual value. The journals required on initial recognition are:
|
|
CU |
CU |
|
Dr Grossed Leased Asset |
50,000 |
|
|
Cr Creditors |
|
50,000 |
Being journal to reflect the recognition of the lease of asset
Then throughout the life the finance income will be journaled. For example the journal required at the end of year one would be:
|
|
CU |
CU |
|
Dr Gross Earnings Allocated to Future Periods on BS |
5,121 |
|
|
Cr Turnover |
|
5,121 |
The receipts into the bank are obviously set against the gross leased asset as they are received.
As can be seen from the above, a key estimation for lessors is the residual value of the asset. Therefore if this change in estimate occurs it is corrected prospectively. The difference between the carrying amount at the date of change in estimate and the recalculated balance using the original effective interest rate is credited or debited to finance income. Note this can be done on the sum of the digits also. In order to determine the required carrying value on the revised residual amount, the present value of future receivables needs to be calculated using the same effective rate.
Example 7: Finance lease accounting for the lessor – change in residual value
If we take example 3 and assume that the estimated residual value at the end of year 3 changes to CU4,500. See below the revised cash flows present valued using the original effective rate:
|
Period Ending |
Cashflows |
Formula to get PV factor |
Discount rate at 13.477% PV factor |
Present Value of Cash Flow |
|
3 |
12,000 |
1 |
1 |
12,000 |
|
4 |
12,000 |
1/(1.13477)^1 |
0.8812 |
10,575 |
|
5 |
12,000 |
1/(1.13477)^2 |
0.7766 |
9,319 |
|
End of Year 5 |
4,500 |
1/(1.13477)^3 |
0.6843 |
3,080 _____________ |
|
Total PV |
|
|
|
34,973 |
We then recalculate the interest to be charged over the remaining years.
|
Year |
Opening Balance |
Rent Received |
Capital Element |
Finance Income for Period 13.477% |
Gross investment allocated at end of period |
Gross earning allocated to future periods |
Net investment at end of period |
|
|
|
|
|
|
|
|
|
|
3 |
34,973 |
12,000 |
22,973 |
3,096 |
37,973 |
11,904 |
26,069 |
|
4 |
26,069 |
12,000 |
14,069 |
1,896 |
25,973 |
10,008 |
15,966 |
|
5 |
15,966 |
12,000 |
3,966 |
534 |
13,973 |
9,473 |
4,500 |
The difference of CU342 between the carrying amount at the end of year 2 as calculated in example 5 of CU35,315 and the recalculated balance at the start of year 3 of CU34,973 is debited against finance income in the year.
Manufacturer or dealer lessors
Extract from FRS 105 – Section 15.21 – 15.23
15.21 Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset. A finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income:
a) profit or loss equivalent to the profit or loss resulting from an outright sale of the asset being leased, at normal selling prices, reflecting any applicable volume or trade discounts; and
b) finance income over the lease term.
15.22 The sales revenue recognised at the commencement of the lease term by a manufacturer or dealer lessor is the fair value of the asset or, if lower, the present value of the minimum lease payments accruing to the lessor, computed at a market rate of interest. The cost of sale recognised at the commencement of the lease term 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 sales revenue and the cost of sale is the selling profit, which is recognised in accordance with the micro-entity’s policy for outright sales.
15.23 If artificially low rates of interest are quoted, selling profit shall be restricted to that which would apply if a market rate of interest were charged. Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a lease shall be recognised as an expense when the selling profit is recognised.
OmniPro comment
Example of where this arises is where car dealers offer cars for sale with 0% finance instead of reducing the price of the car. In these instances where substantially all the risks and rewards of ownership are transferred, then the amount that the manufacturer should recognise in normal trading revenue for the sale of the car is the fair value of the asset or if lower the present value of future minimum lease payments computed at the market rate of interest. The fair value is usually the cash price that would have been charged for the car or if not the sales price obtained less the amount relating to the implicit rate of return. The cost of sale recognised is the cost of the asset less present value of the unguaranteed residual value. The difference between the both is the selling profit. The finance income is then allocated to the P&L over the life of the lease on a straight line basis.
Sale and leaseback transactions
Extract from FRS 105 – Section 15.30 – 15.33
15.30 A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually interdependent because they are negotiated as a package. The accounting treatment of a sale and leaseback transaction depends on the type of lease.
Sale and leaseback transaction results in a finance lease
15.31 If a sale and leaseback transaction results in a finance lease, the seller-lessee shall not recognise immediately, as income, any excess of sales proceeds over the carrying amount. Instead, the seller-lessee shall defer such excess and amortise it over the lease term.
Sale and leaseback transaction results in an operating lease
15.32 If a sale and leaseback transaction results in an operating lease, and it is clear that the transaction is established at fair value, the seller- lessee shall recognise any profit or loss immediately. If the sale price is below fair value, the seller-lessee shall recognise any profit or loss immediately unless the loss is compensated for by future lease payments at below market price. In that case the seller-lessee shall defer and amortise such loss in proportion to the lease payments over the period for which the asset is expected to be used. If the sale price is above fair value, the seller-lessee shall defer the excess over fair value and amortise it over the period for which the asset is expected to be used.
Disclosure in the notes
15.33 A micro-entity shall determine the amount of any financial commitments, guarantees and contingencies not recognised in the statement of financial position arising from a sale and lease back transaction and disclose that amount within the total amount of financial commitments, guarantees and contingencies (see paragraph 6A.2).
OmniPro comment
A sale and leaseback occurs where an entity sells an asset and immediately reacquires the use of the asset by entering into a lease with the buyer. They are usually used to get access to funds.
Where a sale and leaseback occurs and where there is a finance lease created the asset should not be derecognised, instead the proceeds received should be credited to the profit and loss over the life of the lease.
Example 8: Sale and leaseback
Company A owned a property which had a net book value at year end of CU100,000 and had a remaining useful life of 28 years. On the last day of the year the company entered into an agreement whereby it sold the property for CU500,000 and as part of the agreement leases this back from the purchaser for a 25 year period. The annual lease rentals on the property is CU70,000. Given that in substance the company still has the risk and rewards of ownership, the company should account for this transaction as follows:
|
|
CU |
CU |
|
Dr Bank |
500,000 |
|
|
Cr Fixed Assets |
|
100,000 |
|
Cr Accuals/Deferred Income |
|
400,000 |
Being journal to reflect proceeds from the transaction
|
|
CU |
CU |
|
Dr Fixed Asset |
500,000 |
|
|
Cr Finance Lease Liability |
|
500,000 |
Being journal to recognise acquisition of the property under finance lease assuming this equated to fair value.
The accrual/deferred income is allocated over the remaining life of the lease each year i.e. CU400,000 / 25 years = CU16,000 per annum. Therefore on a yearly basis the below journal will be posted:
|
|
CU |
CU |
|
Dr Accruals/Deferred Income |
16,000 |
|
|
Cr Rental Costs P&L |
|
16,000 |
Each year depreciation will be charged on the CU500,000 over its lease term.
The finance lease interest is debited to the profit and loss over the life of the lease as with any other finance lease. The net amount of the depreciation and the rental credit will equate to the previous depreciation that was charged on that asset.
Where the lease is not deemed to be a finance lease, then it is an operating lease and the asset can be derecognised and the profit/loss can be recognised in the P&L. The only exception to this rule is where the sales prices was not at market value i.e. above or below market value and instead the rent is below/in excess of market rent. In this case the loss/profit should be deferred and amortised over the period for which the asset is expected to be used.
For the purchaser it would be a mirror picture.
Disclosures
A company should disclose the amount of any financial commitments, guarantees and contingencies not recognised in the statement of financial position arising from a sale and lease back transaction and disclose that amount within the total amount of financial commitments, guarantees and contingencies. See example disclosure below
Example 9: Sale and leaseback disclosure
The company entered into a sale and lease arrangement with the bank and is committed to leasing back the property on an annual basis for CUXXXXX for X years.
FRS 105 Transition exemptions
OmniPro comment
Section 28.10 of FRS 105 provides an exemption whereby lease incentives received prior to the date of transition do not have to be retrospectively adjusted. Instead the entity can continue to release the accrual over the life determined under previous GAAP. This is likely to be a very beneficial exemption for retailers who have a large number of leases with incentives. Under FRS 105 the lease incentives are recognised over the life of the lease. This contrasts with old GAAP/FRSSE where the lease incentive was released over the shorter of the lease term or over the period from the commencement of the lease to the date of the first market rent review/break clause.
Section 28.10 also allows an entity to carry out an assessment as to whether an arrangement constitutes a lease on the transition date as opposed to determining it at the date the arrangement was entered into.
Principal transition adjustments
1) Lease incentives entered into since the date of transition
Under FRS 105 the lease incentives are recognised over the life of the lease. This contrasts with old GAAP/FRSSE where the lease incentive was released over the shorter of the lease term or over the period from the commencement of the lease to the date of the first market rent review/break clause. The treatment under FRS 102 is the same as FRS 105 therefore there will be no adjustment for entities transitioning from FRS 102 to FRS 105.
Assuming the entity takes the exemption in Section 28.10 to not retrospectively adjust lease incentive accruals prior to the date of transition the only adjustment required will be for any lease incentive received since the date of transition. In this case there will be an impact on the profit and loss for the reduction in the lease incentive credit and the related corporation tax asset to reflect the fact that tax would have been lower in the comparative year had FRS 105 applied (as less of a credit posted for the lease incentive) which will be reimbursed in the tax computation over a 5 year period. If the exemption is not taken then a detailed exercise will need to be performed for each lease incentive similar to the below but will obviously be looking at incentives received pre transition.
Example 10: Lease incentives since date of transition (applicable to entities transitioning from old GAAP/FRSSE)
Company A’s date of transition is 1 January 2015 i.e. 31 December year end. Company A entered into a lease on 2 January 2015 for 10 years with a landlord for a premises it occupies. As part of the agreement the landlord provided a 3 month rent free period (lease incentive of CU200,000/12mths*3mths=CU50,000). The rent payable on the lease per annum is CU200,000. As part of the agreement, the landlord agreed to provide the first 3 months rent free. A rent review/break clause was included which could be initiated at the end of year 5. Under old GAAP, this lease incentive was released to the P&L over the 5 years as was dictated by that GAAP. Therefore at 31 December 2014 the lease incentive accrual under old GAAP was CU40,000 (i.e. the value of the rent free period of CU50,000 / 5 years * 4 years that remain) and the rent cost in the P&L was CU190,000. Assume a corporation tax rate of 10%. The adjustment will be tax deductible over a 5 year period in the tax computation.
Under Section 15, the lease incentive needs to be written off over the life of the lease which is 10 years. See below for the calculation of what should have been accrued at the 31 December 2014.
The journals required to be posted in Company A’s TB at the 31 December 2015 to correct the old GAAP postings are:
|
CU |
CU |
|
|
Dr Rental Expense in P&L (CU45,000-CU40,000) |
5,000* |
|
|
Cr Lease Incentive Accrual BS |
|
5,000 |
Being journal to reverse understatement of accrual under old GAAP
From year 2 on, the CU45,000 is written back to the profit and loss and set against the rental expense i.e. at the end of year 2 the accrual would be reduced to CU40,000 (CU50,000-CU5,000 for 2014 – CU5,000 for 2015) to show the net cost of CU195,000 per annum.
If in the above example the landlord provided a contribution of CU50,000 towards the cost of fixed assets or towards the cost of relocating, the treatment would be the same.
* Calculate the actual total rental payments over the 10 years i.e. actual rent payments are only paid for 9 years and 9 months = CU200,000 *9.75 years= CU1,950,000. Therefore the total amount of rent to be charged over the life of the lease is = CU1,950,000/10 years = CU195,000 per annum or CU16,250 per month. Therefore for the first 3 months an accrual is required as no payment is made. The accrual is then reduced over the life of the lease (the value of the rent free period was CU50,000). Therefore the accrual required at 31 December 2014 was CU45,000 (CU50,000 less the amount utilised in 2014 of CU5,000 (being CU50,000 / 10 years) compared to the old GAAP accrual of CU40,000.
Given that the company has already been taxed on the additional credit posted in old GAAP of CU5,000 and given that if FRS 105 had of been applied in that year the additional CU5,000 would not have been taxed , a corporation tax asset should be recognised for the fact that this will be recouped in future tax computations (assumed tax deductible over 5 years for the purposes of this example.
The journals required in the comparative year are:
|
|
CU |
CU |
|
Dr Corporation Tax Asset (CU5,000*10%) |
500 |
|
|
Cr Corporation Tax P&L |
|
500 |
Being journal to reflect Corporation tax on the above adjustment so as to show the correct tax under FRS 105 as if FRS 105 had of applied from inception.
For the year ended 31 December 2016, a similar adjustment will be required (plus the profit and loss reserve adjustment for 2014), however no corporation tax will be required on the 2016 adjustment as the tax computation has not been submitted to the tax authorities at the time of preparing the financial statements. 1/5th of the corporation tax asset of CU500 recognised in 2015 will have to be released in 2016 for the fact that a deduction will be obtained in the tax computation for this 1/5th in 2016. The journal required is:
|
|
CU |
CU |
|
Dr Corporation Tax in P&L |
100 |
|
|
Cr Corporation Tax Asset |
|
100 |
Being journal to reflect the additional deduction for 1/5th of the credit previously taxed up to 31/12/15 under old GAAP which has therefore fallen out on transition to FRS 105 and if FRS 105 had of been applied in the comparative year, the corporation tax charge would be less. Note this assumes that the tax journal posted will include the transition tax adjustment for the CU100 when it is finally recognised. If there was no corporation tax in 2016, then the CU100 would still be released as a debit to the P&L as it would be no longer refundable from the tax authorities. As no deferred tax can be recognised under FRS 105 it cannot be held as deferred tax asset on the balance sheet as a timing difference if it cannot be utilised. The remaining CU400 (CU500-CU100) will still be included as an asset at the year end in the corporation tax nominal and released over the remaining 4 yrs.
2) Directly attributable transaction costs (applicable to FRSSE/old GAAP entities that transition only
Under FRS 102 directly attributable transaction costs should be capitalised with the finance lease. This was not the case under old GAAP. In the unlikely event that these are material, retrospective adjustment will be required.
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