Accounting for leases

Where appropriate the article makes reference to SSAP 21, Accounting for Leases which is applicable for the UK variant papers but, internationally IAS 17(revised effective from 1 January 1999) Accounting for Leases, in Singapore SAS 15 Accounting for Leases and in Hong Kong HK SSAP 15 are the relevant accounting standards. They all currently adopt the same approach to accounting for leases. The accounting for leases is examinable at both paper 10 accounting and audit practice and paper 13 financial reporting environment. This article has been written for students studying paper 10 accounting and audit practice but it is also relevant to students studying paper 13 financial reporting environment as preparatory work. This article will consider the issues essential to paper 10, including the audit aspects. A second article to be published in next month’s Students’ Newsletter will consider the more advanced issues of leasing relevant to paper 13 students only.

What is a lease?
A lease is simply an agreement between two parties for the hire of an asset. The lessor is the legal owner of the asset who rents out the asset to the lessee. At the end of the lease the asset is returned to the lessor. The lessee will pay a lease rental to the lessor in return for the use of the asset. The accounting treatment for the lease entirely depends on the nature of the lease. For accounting purposes all leases are classified into one of two categories, they are either deemed to be ‘finance leases’ or ‘operating leases’.

What are operating leases?
If you are studying the UK stream and have studied group accounts then you should be aware that FRS 6, Accounting for Acquisitions and Mergers has a similar problem in that it has to provide guidance for distinguishing business combinations between take-overs and mergers. The approach adopted by FRS 6, Accounting for Acquisitions and Mergers is that it goes into a lot of detail in the identification of business combinations which are mergers (i.e., a pooling of interests) but then simply states that all other business combinations must be take-overs. The accounting standards take a similar approach as an operating lease is defined as a lease which is not a finance lease!

At its most clear cut an operating lease is a very short-term agreement for the temporary hire of an asset, e.g., hiring a car for two weeks to take on holiday.

Accounting treatment for operating leases
The accounting treatment for an operating lease is straightforward for both the lessor and the lessee. The lessee has incurred an operating expense, so the lease rental payable is written off in the profit and loss account. The lessee has to disclose in the notes to the accounts the amount charged in the year and the amount of the payments to which the entity is committed at the year end.

The lessor has earned revenue from renting out the asset and accordingly recognises the lease rental receivable as income in the profit and loss account.

What are finance leases?
A finance lease is one where the risks and rewards of the ownership pass to the lessee. How it is determined that risks and rewards have passed is a subjective issue and one on which accounting standards give guidance (see below). At its most clear cut, however, a finance lease is a long-term agreement representing a loan made by the lessor to the lessee to buy the asset.

Legally, of course, a finance lease is a rental agreement, and legally the lessee has not bought the asset as title remains with the lessor. However, to account for the finance lease in accordance with its legal form would be a betrayal of the concept of ‘substance over form’. This important concept (identified as such in both the Accounting Standards Board draft Statement of Principles for Financial Reporting and the International Accounting Standards Committee’s Framework for the Preparation and Presentation of Financial Statements) requires that the commercial reality of events and transactions be reported in the financial statement if they are to be relevant to the users of the financial statements and if the financial statements are to be true and fair.

Accounting treatment of finance leases - by the lessee
When a lessee enters into a finance lease it is getting access to the risks and rewards of the asset and accordingly the lessee reflects substance by recognising the asset in its own accounts. This is consistent with the ASB’s Statement of Principles definition of and recognition criteria of an asset.

When a lessee enters into a finance lease it is obliged to make the lease rental payments for the duration of the lease, and accordingly the lessee reflects the substance by recognising a liability. This is consistent with the ASB’s Statement of Principles definition of and recognition criteria of a liability.

The lessee strictly capitalises the present value of the minimum lease payments as the fixed asset and this is the amount also recorded as the liability. The present value of the minimum lease payments normally equates to the cash price. The asset has to be depreciated over the shorter of the period of the lease and the useful life of the asset. The loan accrues interest which should be recognised to give a constant periodic return on the balance of the outstanding loan. The rental payment is not therefore simply a revenue expense but represents partly the repayment of the capital element of the loan and partly the finance charge on the loan (i.e., interest). The total finance charge is the difference between the minimum lease payments and the present value of the minimum lease payments.

This can all be explained again in double entry terms!

When a finance lease is entered into the lessee has to record an asset and a liability:

On the balance sheet the finance lease creditor obligation under finance leases will have to be split between current and long-term creditors. In the notes to the balance sheet a separate listing in the fixed asset schedule is required to distinguish assets legally owned and those held subject to finance leases. In the notes to the profit and loss account the amount of the interest charged that was in respect of finance leases must be disclosed.

Accounting treatment of finance leases - by the lessor
Such lessors are normally banks or similar lending institutions. When entering into a finance lease the lessor is in substance making a loan which will be repaid with interest. Despite having legal title to the asset subject to the lease, the lessor does not recognise this as an asset on its balance sheet, as it does not control the asset and does not have access to the future economic benefits. The lessor does however have the asset of a future income stream and accordingly recognises a debtor ‘net investment in finance leases’ .

Why is the classification of leases important?
To recap, if a lease is classified and correctly accounted for as a finance lease, the lessee will recognise an asset, but more significantly a liability as well; but if the lease is treated as an operating lease then no liability is recognised in the lessee’s financial statements. Some companies may be concerned about the level of debt included on the balance sheet, as this will increase the reported gearing ratio. A high gearing ratio might be perceived as undesirable if, for example, the company was looking to borrow more funds. It might prove more difficult or expensive to do so as the company’s accounts would already include high liabilities. Accordingly lessees may well have a preference to account for a lease as an operating lease rather than a finance lease to take the liability off the balance sheet. Prior to the introduction in the UK of SSAP 21, Accounting for Leases many lessees did not distinguish between the two types of leases and accounted for all leases in accordance with their legal form. It is argued that this amounted to creative accounting as it took liabilities off the balance sheet.

How are leases classified?
The classification of a lease as either a finance lease or an operating lease hinges on whether the risks and rewards of ownership pass to the lessee. This is subjective and it is important that all the terms of the lease are reviewed so that the substance of the lease agreement can be identified. For example:

• Repairs, maintenance, insurance

If the lessee is responsible for repairing, maintaining and insuring the asset then this is consistent with the behaviour of the owner of the asset, and would support the contention that the lease is a finance lease. In these circumstance the lessee has the risk of the cost of repairs and of idle time but has the reward if the asset never breaks down!

• Length of the lease

If the lease period is for substantially all of the assets estimated useful economic life, then this would support the argument that the lease was a finance lease. The lessee would be the beneficiary of the economic value of the asset as only an immaterial residue value would be returned to the lessor.

• Bargain options

If the lease contains a clause to the effect that the lessee can either renew the lease or buy the asset at the end of the lease term for a peppercorn (notional) amount then this would support the contention that the lease is a finance lease. The lessee will enjoy the reward if the asset turns out to have a longer than expected life. It suggests that the lessee will have exclusive access to the future economic benefits of the asset which is consistent with the concept that the asset ‘belongs’ to the lessee even though the lessee does not have legal title.

• The 90% test

If at the inception of the lease the present value of the minimum lease payments amounts to substantially all (90% or more) of the fair value of the leased asset (this normally equates to the cash price), it is presumed to be a finance lease. It is often commented that this test is over relied on in practice. It should be noted that the 90% test is a guide not a rule.

Question

Often the key to passing the paper 10 accounting and audit practice exam is being able to master the compulsory 30 mark Question 4 which is an integrated accounting and audit question. Typically this question takes a single topic and seeks to examine the accounting and auditing aspects. Leasing has yet to be examined in this way but does lend itself to being the subject of Question 4 as the auditing of leases is not examined at paper 6 Audit Framework. The following is a question and answer that I have written to show you how this topic may be examined at paper 10.

Answer to Charlie plc and his leases

• Machine A - Henry

The lease is for the whole of the asset’s life. Charlie plc is responsible for maintaining, repairing and insuring the asset. These points suggest that Charlie plc will exclusively benefit from the asset and have the responsibilities associated with ownership.

It is noted that there is an option for Charlie plc to buy the asset at the end of the lease at a notional sum so that, if the asset does have some residual value, Charlie plc will benefit.

This lease is a finance lease i.e., Charlie plc is really borrowing cash to buy the asset even though Charlie plc does not obtain legal title during the lease.

Charlie plc will pay a total of £10,000 for an asset with a cash price of only £7,710. The difference of £2,290 will represent the total finance charge to be allocated to the profit and loss account as interest.

It is even possible to compute that the present value of the minimum lease payments amount to 100% of the cash price (fair value) of the asset.

Tutorial note

It is necessary for you to be familiar with the working below calculating the present value of the minimum lease payments — but strictly in this question it is an unnecessary calculation.

The present value of minimum payment amounts to 100% of the fair value of £7,710.

• Machine B - Alexander

Charlie plc is responsible for insuring the asset which suggests that this could be a finance lease.

However, the lease can be cancelled at any time by either party giving only six months’ notice in respect of an asset that has a life of 10 years. Charlie plc does not control the access to the future economic benefits of the asset as the lessor can serve notice to recall the asset at any time.

The minimum lease payments are only for six months i.e., £36,000 and this is nowhere near 90% of the fair value (cash price) of £500,000.

This lease is definitely an operating lease!

• Machine C - Brampton

The period of the lease agreement is for only half of the asset’s life which suggests that it is an operating lease. It is reasonable to presume that the asset will still have a high residual value when it is returned, indeed there is no mention of any terms to suggest that it will not be returned to the lessor.

The minimum lease payments as a proportion of the cash price (fair value) of the asset even before discounting comes to only 50%.

This lease is another operating lease.

(b) Workings for the Machine A finance lease creditor

The initial recording of the finance lease is to capitalise the cash price

DR Fixed assets 7,710
CR Creditors 7,710

The first working is the movement on the finance lease creditor. Note that the sum of the finance charges £2,290 is a familiar figure.

The annual depreciation charge using the straight line method is £7,710 divided by 4 years = £1,927.5

On the balance sheet the obligation to the finance lease creditor needs to be split between current and long-term liabilities. There is no need to accrue for any interest as a lease payment has just been made. The current liability is the capital element of next year’s lease payments i.e., next year’s payments net of the future interest. The long-term element of the creditor is the balance of the year end liability.

Machine A - Henry the finance lease

Profit and loss extracts

Machine B - Alexander’s operating lease

Profit and loss extracts

Balance Sheet extracts

None

Machine C - Brampton’s operating lease

Profit and loss extracts

Balance Sheet extracts

(c) Audit procedures

The principle audit risk, associated with leases concerns their classification. If what are in substance loans to buy fixed assets are accounted for as operating leases, then the financial statements will not show a true and fair view, as there will be off balance sheet assets and liabilities. This risk is higher if the company’s gearing may be considered too high.

Assuming that the auditor is not newly appointed, attention first needs to be given to the classification of the leases entered into in the accounting period and their accounting treatment.

It is necessary to gather evidence in respect of each new lease (or a sample if appropriate) as to which party to the lease is bearing the risks and rewards of ownership. It might be that a company has standard lease terms with just one or two lessors. If there are a large number of leases with a few lessors (which is common) confirmation should be sought direct from each lessor as to how many lease agreements the entity has. This will provide good audit evidence of existence and cut off.

A copy of the lease must be obtained (preferably from the lessor rather than the client’s own files in order to improve the quality of the audit evidence), read, and the substance of the agreement understood.

Clauses in the lease relating to maintenance costs, the period of the lease relative to the useful life of the asset, bargain purchase options and the present value of the minimum lease payments relative to the fair value (cash price) will be important. If the client has to maintain the asset in good repair, and if the period of the lease is for the whole of the asset’s life, and if the client has a bargain purchase option and if the present value of the minimum lease payments is at least 90% of the fair value of the asset, then it is a finance lease and the financial statements must reflect both an asset and a liability.

It is not sufficient just to rely on the 90% test rather it is important the substance of the lease is considered.

In addition, the following work should be performed in respect of the finance leases.

The disclosures required by the standard should also be checked for compliance, in particular the accounting policy note and the note with regard to continuing obligations in respect of operating leases.

Conclusion
More on leases next month including accounting for sale and lease back arrangements and the latest proposal from the G4 + 1 group on the future of accounting for leases.