Periodically we seem to attract a flurry of questions about how to account for leased assets, specifically from the lessee's perspective. Being accountants we love those questions!
Businesses reporting under International Financial Reporting Standards will now find that, for accounting periods beginning on or after 1 January 2019, most leased assets will be recognised on the balance sheet (unless the lease is very short term or the assets are of very low value).
Most smaller businesses in the UK report under UK Financial Reporting Standards, where the position is rather different - at least for the time being.
The UK Financial Reporting Standard 102 (FRS 102) takes a "risks and rewards" approach to lease classification and is in many respects very similar to the 'old' accounting standard SSAP 21 which it superceded.
Under FRS102, a lease is classified as either a "finance lease" - if it transfers substantially all the risks and rewards incidental to ownership - or else as an "operating lease"- if it does not.
Where a lease amounts to a "finance lease", the lessee:
- at the beginning of the lease recognises both the asset and the liability in the balance sheet - normally at the fair value of the asset or, if lower, the present value of the minimum lease payments;
- during the lease apportions the payments between interest charges (which are booked to the profit & loss account) and capital (which are set against the liability in the balance sheet); and
- during the lease depreciates the asset over an appropriate time period.
Where a lease is classified as an "operating lease", the lessee does not recognise an asset or liability at the beginning of the lease; instead the lease payments are recognised as an expense in the profit & loss account over the lease term, normally on a straight line basis.
The Financial Reporting Council has published a useful Staff Education Note that outlines a list of situations which individually or in combination would normally point to a lease being classified as a finance lease:
- ownership of the asset transfers to the lessee by the end of the lease term;
- the lessee has the option to purchase the asset at a significant discount to its likely value at the time the option becomes exercisable;
- the lease term is for the major part of the expected economic life of the asset (even if title is not transferred);
- the present value of the total minimum payments under the lease equates to the fair value of the leased asset (or close to it);
- the leased assets are so specialised that only the lessee can use them without modification.