Leases

Section 20 of FRS 102 covers accounting for all leases other than:

• leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources;
• licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights;
• measurement of property held by lessees that is accounted for as investment property and measurement of investment property provided by lessors under operating leases;
• measurement of biological assets held by lessees under finance leases and biological assets provided by lessors under operating leases; and
• leases that could lead to a loss to the lessor or the lessee as a result of non-typical contractual.

What types of leases are covered?

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.

As well as more standard leases (with the above exceptions), section 20 also includes 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. But 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.

How are leases classified?

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.

[[[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.]]]

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. FRS 102 includes examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease.

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.

How are leases recognised and measured?

Finance leases

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.

Operating leases

Lease payments (excluding costs for services such as insurance and maintenance) are recognised as an expense over the lease term on a straight-line basis unless either:

1. another systematic basis is representative of the time pattern of the user’s benefit, even if the payments are not on that basis; or
2. the payments to the lessor are structured to increase in line with expected general inflation (based on published indexes or statistics) to compensate for the lessor’s expected inflationary cost increases.

A lessee shall recognise the aggregate benefit of lease incentives as a reduction to the lease expense over the lease term, on a straight-line basis unless another systematic basis is representative of the time pattern of the lessee’s benefit from the use of the leased asset.

Section 20 also deals with lessors’ treatment of finance leases and sale and leaseback transactions resulting in an operating lease.

What lease disclosures are needed?

A lessee shall disclose the total of future minimum lease payments under non-cancellable operating leases for each of the following periods:

• not later than one year;
• later than one year and not later than five years; and
• later than five years; and

Lease payments recognised as an expense should also be disclosed.

How is this different to ‘old GAAP’?

The overall approach adopted by FRS 102 is very similar to current UK and Irish GAAP. However the following minor differences should be noted:

Finance leases – lessee accounting

Under SSAP 21 the initial measurement of the asset and liability is at the present value of minimum lease payments, discounted at the rate implicit in the lease. Under FRS 102 the assets and liability are recorded at the lower of the fair value of the leased item and the present value of the minimum lease payments using the interest rate implicit in the lease.

Finance leases – lessor accounting

The accounting is very similar, although the detailed definitions of gross investment; net investment; and net cash investment are different.

Operating leases – lessee accounting

SSAP 21 provides no guidance on the treatment of inflationary increases. FRS 102 implies that these increases are expensed as incurred.

Sale and leaseback transactions

The basic treatment currently set out in UK and Irish GAAP is the same as FRS 102, but guidance is also given on ways of deferring and recognising a gain.

Lease incentives

Currently under UK and Irish GAAP the value of the lease incentives are recognised against the value of lease payments to be recognised on a straight line basis up to the point when the lease resets to market rates. FRS 102 recognised lease incentives over the term of the lease.

Are there any exemptions on transition?

Yes – the existing UK and Irish GAAP treatment for operating lease incentives (see above) can be continued for leases whose inception occurred prior to the date of transition. This is important for lessors as it allows them to avoid unfavourable tax cash flows which would arise from the new approach in FRS 102.