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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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20.4 Classification of leases
20.4.1 Extract from FRS 102 – Section 20.4- 20.7
20.4 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.
20.5 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 amounts to at least substantially all of the fair value of the leased asset;
AND
(e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications
20.6 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 (e.g. 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.
20.4.2 OmniPro comment
20.4.2.1 Risks and rewards of ownership
As is stated in Section 20.4 of FRS 102, 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. If risks and rewards do not transfer it is an operating lease as stated in section 20.4 of FRS 102.
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. See further details at 20.5.2.
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.
20.4.2.2 Lease term defined and major part of an asset life – option to extend.
The lease term in defined in FRS 102 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 that 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.
20.4.2.3 Substance over form
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.
20.4.2.4 Indicators suggesting a finance lease exists
Indicators which individually or combined may indicated a finance lease exists (as stated in Section 20.5 and 20.6 of FRS 102) 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 amounts to at least substantially all of the fair value of the leased asset;
(e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications
(f) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
(g) gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee (e.g. in the form of a rent rebate equalling most of the sales proceeds at the end of the lease);
(h) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
(i) where substantially the risk and rewards of ownership transfer (section 20.4 of FRS102)
20.4.2.4.1 Option to purchase at end of lease – put and call options / residual value guarantees. Section 20.5 (b) FRS102
Title does not have to be transferred in order for it to be a finance lease. In practice where point b in Section 20.5 (b) of FRS102 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.
In relation to section 20.6(b) of FRS 102, 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 estimated 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, this this would indicate the presence of 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 of the option is exercised thereby indicating an operating lease. See application of the aforementioned at example 1 below.
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%).
20.4.2.4.2 Meaning of substantially in respect to present value of future payment Section 20.5(d) of FRS 102
Section 20.5(d) of FRS 102 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 20, 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 20.5-20.6 above. See the application of this test in example 2 at 20.6.2.6 Note an 85% test could also be utilised.
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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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