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Section 20: Leases.
20.2.1 Extract from FRS 102 – Section 20.1-20.2.
20.2.2 OmniPro comment – Scope.
20.3 Determining whether an arrangement contains a lease.
20.3.1 Extract from FRS 102 – Section 20.3- 20.3A.
20.4 Classification of leases.
20.4.1 Extract from FRS 102 – Section 20.4- 20.7.
20.4.2.1 Risks and rewards of ownership.
20.4.2.2 Lease term defined and major part of an asset life – option to extend.
20.4.2.4 Indicators suggesting a finance lease exists.
20.4.2.4.1 Option to purchase at end of lease – put and call options / residual value guarantees.
20.4.2.4.2 Meaning of substantially in respect to present value of future payment
20.5 Change in lease classification.
20.5.1 Extract from FRS 102 – Section 20.8.
20.6 Initial recognition and subsequent measurement-financial statements of lessees: finance leases
20.6.1 Extract from FRS 102 – Section 20.9- 20.12.
20.6.2.2 Interest rate implicit in the lease.
20.6.2.3 Minimum lease payments including options to extend.
20.6.2.4 Depreciation of leased assets.
20.6.2.6 Lessee: Initial and subsequent measurement – finance lease.
20.7.1 Initial Recognition and subsequent measurement
20.7.1.1 Extract from FRS 102 – Section 20.15-20.15B.
20.7.1.2.2 Time when expense is recognised.
20.7.1.2.3 Costs directly incurred in negotiating/arranging lease.
20.7.1.2.4 Treatment of termination penalties.
20.7.1.2.5 Operating leases with payment linked to other variables.
20.8 Initial recognition and subsequent measurement -financial statements of lessors: finance leases
20.8.1 Extract from FRS 102 – Section 20.17-20.19.
20.9 Manufacturer or dealer lessors.
20.9.1 Extract from FRS 102 – Section 20.20-20.22.
20.10 Financial statements of lessors: operating leases.
20.10.1 Extract from FRS 102 – Section 20.24-20.25 and Section 20.27-20.29.
20.10.1.1 Recognition and measurement
20.10.1.2.2 Time when expense is recognised.
20.10.1.2.3 Costs directly incurred in negotiating/arranging lease.
20.10.1.2.4 Operating lease with payments linked to other variables.
20.10.1.2.5 Lease incentives – lesser
20.11 Sale and leaseback transactions.
20.11.1 Extract from FRS 102 – Section 20.32-20.34.
20.11.2.1 Sales and lease back defined.
20.11.2.2 Sales and lease back – finance lease.
20.11.2.3 Sales and lease back – operating lease.
20.12.1 Disclosures for operating leases – Lessors.
20.12.1.1 Extract from FRS 102 – Section 20.30.
20.12.1.2.1 Accounting policy note.
20.12.1.2.2 Extract from notes to the financial statements.
20.12.2 Disclosures – Operating leases for lessees.
20.12.2.1 Extract from FRS 102 – Section 20.
20.12.2.2.1 Accounting policy example.
20.12.2.2.2 Notes to the financial statements.
20.12.3 Sale and leaseback disclosures.
20.12.3.1 Extract from FRS 102 Section 20.35.
20.12.4 Disclosures – financial statements of lessees: finance leases.
20.12.4.1 Extract from FRS 102 – Section 20.13- 20.14.
20.12.4.2.1 Accounting policy disclosures.
20.12.4.2.2 Extract from notes to the financial statements.
20.12.5 Disclosures – financial statements of lessors: finance leases.
20.12.5.1 Extract from FRS 102 – Section 20.23.
20.12.5.2.1 Accounting policy disclosure.
20.12.5.2.2 Extract from notes to the financial statements
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The below extracts and guidance is applicable for periods beginning before 1 January 2019 and are based on the September 2015 version of FRS 102. For periods beginning on or after 1 January 2019, the March 2018 version of FRS 102 applies which incorporates the changes made by the Triennial review of FRS 102. Note the March 2018 version of FRS 102 can be voluntarily applies for periods beginning before 1 January 2019. For the extracts from the March 2018 version of FRS 102 and the related guidance please click on the following link. For details of a summary of the main changes as a result of the triennial review please see the following link.
20.6 Initial Recognition and Subsequent Measurement – Financial Statements of Lessees: Finance Leases
20.6.1 Extract from FRS 102 – Section 20.9- 20.12
20.9 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.
20.10 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
20.11 A lessee shall apportion minimum lease payments between the finance charge and the reduction of the outstanding liability using the effective interest method (see paragraphs 11.15 to 11.20). 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.
20.12 A lessee shall depreciate an asset leased under a finance lease in accordance with Section 17 Property, Plant and Equipment. 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 27 Impairment of Assets).
20.6.2 OmniPro comment
20.6.2.1 Overview
Section 20.9 and 20.10 of FRS 102 requires a lessee to recognise it rights of use and obligations on the balance sheets at lower of the present value of the minimum lease payments discounted at the market rate implied in the lease or the fair value of the asset including direct costs.
20.6.2.2 Interest rate implicit in the lease
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) 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.
20.6.2.3 Minimum lease payments including options to extend
The minimum lease payments are defined by Section 20 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.
20.6.2.4 Depreciation of leased assets
From a fixed asset point of view, as stated in section 20.12 of FRS 102 the assets should be depreciated over the shorter of their useful life or lease term if there is no reasonable certainty that the lessee will obtain ownership by the end of the lease. If the lease term is shorter it is depreciated over that term unless the entity can prove that it is likely that they will hold onto the asset after the lease term, in which case the actual useful life can be used (where longer than the lease term)
20.6.2.5 Impairments
Section 20.12 of FRS 102 required finance leased assets to be reviewed for impairment indicators as detailed in 27.5.2 at each reporting date. If an impairment is required it should be written off to the profit and loss account as detailed at 27.10.2
20.6.2.6 Lessee: Initial and subsequent measurement – finance lease
See application of the rules in Section 20.11 of FRS 102 for accounting for a finance lease at initial recognition and subsequently
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. See calculation below. The effective interest rate amount 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 effective interest rate (obtained through an excel formula). 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 effective 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 as required by Section 20.4 and 20.5 (d) of FRS 102.
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.
Detailed below are the balances to be booked in subsequent periods:
| 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 |
The finance charge posted at the end of year 1 is CU4,763 and so on for subsequent years (Cr finance lease liability and Dr finance charge). While not mentioned in Section 20, under old GAAP the sum of the digits method was allowed. It may be still appropriate to use this method if it creates a charge which is not fundamentally different from the effective interest method.
From a fixed asset pint of view , as stated in section 20.12 of FRS 102 the assets are deprecated over the sorter of their useful life or lease term, if there is no reasonable certainty that the lessee will obtain ownership by the end of the lease. As the lease term is shorter this is deprecated 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 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. 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 |
20.6.2.7 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.
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Example 1: Residual value guarantee.
Example 2: Changes in lease classification.
Example 3: Accounting for finance leases – initial recognition and subsequent measurement– Lessee
Example 4: Operating lease with inflationary increases.
Example 4A: Leases linked to general inflation indexes.
Example 6: Finance lease accounting for the lessor
Example 7: Finance lease accounting for the lessor – change in residual value.
Example 8: Operating lease with inflationary increases.
Example 10: Sale and Leaseback
Example 10A: Extract from an accounting policy note and the related disclosures – Operating Lease.
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