TT234: FRS102 – Leases (s20)

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Introduction

31 December 2015 has been the point for many companies to adopt FRS102. Under this new accounting standard there are many potential changes that need to be considered in terms of the treatment of certain transactions, how these should be accounted for, the disclosure requirements and the potential tax consequences. The focus of this particular topical tip is the impact on the treatment of leases from a lessee perspective.

Definitions under FRS102

Finance lease – A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership.

Operating leases – A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

Recognition, presentation and disclosure

Determining whether a lease is a finance lease or an operating lease is based on the substance of the contract rather than the form of the contract.

Classification is decided at the inception of the lease and is not changed during the term of the lease unless the two parties to the lease agree to change the provisions of the agreement in which case it would need to be re-evaluated.

Finance leases

A lessee shall recognise a finance lease as an asset and a liability 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. This will include any direct costs attributed to negotiating or arranging a lease.

The present value of the minimum lease payments should be calculated using the interest rate per the lease. If this cannot be determined then the lessee’s incremental borrowing rate should be used. Subsequent measurement involves the lessee apportioning the minimum lease payments between the finance charge and the reduction of the outstanding liability using the effective interest method.

In terms of disclosure, there is very little change compared with the old UK GAAP. The accounts still need to disclose the net book value of assets held under finance leases, and also age the finance lease liability.

Operating leases

Under general terms, a lessee shall recognise lease payments under operating leases (excluding service costs BUT including any lease incentives) as an expense over the term of the lease on a straight line basis.

There are two exceptions to this rule, as follows:

  • Another systematic basis is representative of the time pattern of the user’s benefit, even if the payments are not on that basis.
  • The payments to the lessor are structured to increase in line with expected general inflation (based on published data) to compensate for the lessor’s expected inflationary cost increases.

The disclosure of operating lease commitments is a major change in the accounts under FRS102. Under the old UK GAAP, the operating lease commitment note required the entity to disclose the annual expected operating lease charge commitment, classified within the relevant lease end date category. FRS102 on the other hand requires the total of future minimum lease payments under non-cancellable operating leases to be split between the periods in which they are due.

Example

A company incepts a 5 year operating lease on a property on 1 January 2014 and is preparing its accounts for the year ended 31 December 2015. The annual commitment is £360,000 per annum.

Under old UK GAAP as at 31 December 2015

       <1 year      1 – 5 years        >5 years
Land and buildings £ –  £360,000    £ –

Under FRS102 as at 31 December 2015

       <1 year      1 – 5 years        >5 years
 Land and buildings        £360,000£720,000£ –

Transitional rules

UK entities transitioning from old UK GAAP (SSAP 21) to new UK GAAP must prepare their first financial statements as though the requirements of section 20 of FRS 102 had always applied. There are however, certain exemptions for first time adopters under section 35 of FRS102, with those applicable to lessee accounting detailed below.

Although the accounting treatment of finance leases and operating leases is similar under FRS102 to the old UK GAAP, entities can examine those leases where the classification of the type of lease was considered borderline (e.g. where the substance of the transaction could suggest the risks and rewards are with the lessee, contrary to the actual contract in place). First time adopters can elect to use the facts at transition to determine the classification of a lease rather than use the treatment of the lease under old UK GAAP. Clearly in cases where the leases are chosen to be reclassified, there will be an impact on the profit and loss account and the balance sheet, and an adjustment to retained profits on transition.The other exemption applicable to leases under section 35 is in respect of lease incentives. FRS102 requires lease incentives to be recognised over the period of the lease on a straight line basis, whereas under the old UK GAAP the incentive is spread to the period of the next rent review. First time adopters can choose to keep the existing treatment for leases incepted prior to the transition date. However, should the first time adopter choose to adopt the new treatment, again this would result in an adjustment to the retained profits and impact the tax treatment going forward.OtherFurther details of the accounting treatment of leases can be found in Section 20 of FRS102 or any specific queries can be directed to us.

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