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[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section admin_label=”Section” fullwidth=”off” specialty=”off”][et_pb_row admin_label=”Row”][et_pb_column type=”1_2″][et_pb_text admin_label=”Text” background_layout=”light” text_orientation=”center” text_font_size=”14″ use_border_color=”off” border_color=”#ffffff” border_style=”solid”] [button link=”http://www.frs102.com/members/premium-toolkit/” type=”big” color=”red”] Return to Main Index[/button] [/et_pb_text][/et_pb_column][et_pb_column type=”1_2″][et_pb_text admin_label=”Text” background_layout=”light” text_orientation=”center” text_font_size=”14″ use_border_color=”off” border_color=”#ffffff” border_style=”solid”] [button link=”https://uk.frs102.com/members/premium-toolkit/section-20/” type=”big” color=”red”] Return to Section 20 Home[/button] [/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section admin_label=”Section” fullwidth=”off” specialty=”off” transparent_background=”off” allow_player_pause=”off” inner_shadow=”off” parallax=”off” parallax_method=”off” padding_mobile=”off” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” make_equal=”off” use_custom_gutter=”off” gutter_width=”3″][et_pb_row admin_label=”Row”][et_pb_column type=”4_4″][et_pb_text admin_label=”Main Body Text” background_layout=”light” text_orientation=”justified” use_border_color=”off” border_color=”#ffffff” border_style=”solid”]Section 20: 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
Extract from FRS 102 – Section 20.1-20.2
20.1 This section covers accounting for all leases other than:
(a) leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources (see Section 34 Specialised Activities);
(b) licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights (see Section 18 Intangible Assets other than Goodwill);
(c) measurement of property held by lessees that is accounted for as investment property and measurement of investment property provided by lessors under operating leases (see Section 16 Investment Property);
(d) measurement of biological assets held by lessees under finance leases and biological assets provided by lessors under operating leases (see Section 34);
AND
(e) leases that could lead to a loss to the lessor or the lessee as a result of non- typical contractual terms (see paragraph 12.3(f)).
20.2 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.
OmniPro comment
In relation to point c 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 relation to point e above, contingent rents are specifically scoped into Section 20. 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 20 and are not what is referred to in part e above.
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.
Determining whether an arrangement contains a lease
Extract from FRS 102 – Section 20.3- 20.3A
20.3 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.
20.3A 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.
OmniPro comment
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 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.
20.7 The examples and indicators in paragraphs 20.5 and 20.6 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.
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 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.
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 20.5 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 favourable 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 20.5(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 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 1 below.
In relation to point 20.6(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, this this would indicate the presence of finance lease. Where put and call options are a feature of the lease, an assessment wil 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.
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%).
Change in lease classification
Extract from FRS 102 – Section 20.8
20.8 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
Once a lease has been classified as an operating or finance lease at inception is does not change 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.
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.
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