Current accounting treatment SSAP 21 classifies leases as finance leases and operating leases. A finance lease is a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. SSAP 21 includes a presumption that if the present value of the minimum lease payments amounts to 90% or more of the fair value of the leased assets, the lease is a finance lease. An operating lease is a lease other than a finance lease.
Accounting treatment under FRS 102 Under FRS 102 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. FRS 102 does not include a presumption for the classification of a finance lease based on the present value of the minimum lease payments but indicates that the classification of a lease depends on the substance of the transaction rather than the form of the contract.
FRS 102 also includes examples of situations in which a lease would be normally classified as a finance lease; such as:
a) the lease transfers ownership of the asset to the lessee by the end of the lease term b) the lessee has an option to purchase the asset at a price sufficiently lower than fair value at the date the option becomes exercisable that it will be reasonably certain at the inception of the lease that the option will be exercised c) the lease is for the major part of the asset’s economic life even if the 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 (in this example there is no mention of the 90% threshold) e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications.
Further indicators of situations that could result in a lease being classified as a finance lease are:
a) lessor’s losses associated with the cancellation of the lease are borne by the lessee b) gains or losses from the fluctuation of the residual value of the leased asset accrue to the lessee c) the lessee has the ability to continue to lease the asset for a secondary period for a rent substantially lower than market rent.
Transition period Under FRS 102, there is no 90% guideline this is likely to result in a different classification of some leases. For example, leases exceeding 90% of the asset’s fair value may be more easily classified as operating leases if they effectively do not transfer all the risks and rewards of ownership. Conversely, leases whose present value of payments does not approach 90% of fair value may be classified as finance leases by looking at the substance of the contract.
Financial impact The financial reporting impact of recognising a lease as an operating lease rather than as a finance lease is well known. For a lessee an operating lease results in a constant expense in the profit or loss over the term of the lease with little or no effect on the financial position of the entity, while a finance lease results in the immediate recognition of the fair value of the leased asset and a corresponding liability that may have a material effect on the financial position of the entity.
In terms of financial results the difference between classifying a lease as an operating lease or a finance lease is unlikely to be very material; the rental expenses in the profit or loss for an operating lease will be constant while a finance lease will result in a depreciation charge of the capitalised leased asset and a finance charge which will be higher at the beginning of the lease term. However, the impact on the financial position of a lessee in classifying a lease as a financial lease is mainly derived by the liability, equal to the fair value of the leased asset, recognised at the commencement of the lease term.
In respect of a substantial asset capitalised under a finance lease the corresponding liability recognised is likely to increase the entity’s gearing ratio and therefore may result in the breach of debt covenants. A capitalised leased asset may also result in the potential breach of non-financial debt covenants that may restrict capital expenditure beyond certain limits without approval.
Taxation impact of the changes HMRC guidance in respect of finance leases is still applicable for companies using FRS 102. For a finance lease, if the proper accounting treatment has been applied in a lessee's accounts, no adjustments will normally be necessary in the tax computation as correctly prepared accounts normally give the right treatment for tax purposes without further adjustments in the tax computation. The charge for depreciation of the leased asset must not be added back in the lessee's tax computation (it does not relate to capital expenditure by the lessee) nor must the lessee's profit or loss on sale of the leased asset be adjusted in the tax computation.
The total of the depreciation charged in respect of the leased asset, adjusted for any profit or loss on sale, is equal to the total rentals paid less the finance charge element (charged against profits separately) and adjusted for rebates (or sometimes additional rental payments) on termination of the lease.