A lease separates the legal ownership of an asset from its use. The legal owner (lessor) allows the user (lessee) to enjoy the use of the asset, in return for periodic cash instalments.
WHY DO LEASE ACCOUNTING RULES EXIST?
The lease accounting rules are an application of the ‘substance over form’ principle. Put simply, any leasing arrangements, which are effectively:
- ownership of the asset; and
- linked borrowings,
must be accounted for by the lessee as if they were an outright borrowing. These arrangements are known as ‘finance leases’. Importantly, the lessee must include an appropriate finance lease liability in its balance sheet (comparable with a loan taken out to finance the capital cost of the asset). This is the inherently harder (and different) part of lease accounting.
All other leases – known as ‘operating leases’ – are accounted for more simply in exactly the same way as any other standard expense.
WHAT IS THE DIFFERENCE BETWEEN A FINANCE LEASE AND AN OPERATING LEASE?
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LEASE ACCOUNTING: A SUMMARY |
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FINANCE LEASE |
OPERATING LEASE |
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Finance lease liability |
Yes. Initially at fair value of asset |
No |
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Non-current asset |
Yes. Initially at fair value of asset |
No |
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Depreciation |
Yes. Over shorter of (1) lease term; and (2) expected useful life |
No |
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Finance charge |
Yes = Difference between total lease payments and fair value. Spread by (1) sum-of-digits method; or (2) actuarial method |
No |
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Operating lease expense |
No |
Yes |
The best way to look at it is to consider (1) the total lease payments, compared with the initial fair value of the asset; and (2) the lease term, compared with the expected useful life of the asset.
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(1) TOTAL LEASE PAYMENTS |
(2) LEASE TERM |
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FINANCE LEASE |
GREATER than fair value of asset |
Roughly equal to expected useful life |
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OPERATING LEASE |
LESS than fair value of asset |
Significantly less than expected useful life |
In the case of a finance lease: (1) the total lease payments normally cover the entire fair value of the asset, plus a return on top for the owner/lessor; and (2) the remaining useful life at the end of the lease – if any – is not significant.
CALCULATING TOTAL PAYMENTS
Many of us find the number of payments between two inclusive dates: (1) obvious for very short periods; but (2) strange for very long periods (with one more payment than we might have expected). Consider the table below, relating to three different leases:
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FIRST ANNUAL PAYMENT |
LAST ANNUAL PAYMENT |
TOTAL NUMBER OF ANNUAL PAYMENTS |
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SHORT LEASE |
2013 |
2014 |
2 |
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MEDIUM LEASE |
2013 |
2019 |
HOW MANY? |
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LONG LEASE |
2013 |
2031 |
HOW MANY? |
The short lease has two payments, in 2013 and 2014. This can also be calculated from the related years as (2014 – 2013 = 1) + 1 = 2.
The pattern here is that:
Total number of annual payments = difference in years + 1
The medium lease has seven payments (not six), in 2013, 2014, 2015, 2016, 2017, 2018 and 2019. This can similarly be calculated as (2019 – 2013 = 6) + 1 = 7.
In the same way, the long lease has 19 payments (not 18), in 2013 to 2031 inclusive, if you can count all these years individually and not lose count. Or this can more quickly be calculated as (2031 – 2013 =18) + 1 = 19.
HOW MANY MONTHS SHOULD BE ACCOUNTED FOR?
It’s important to remember that you don’t always charge for a full year. For example, if a lease was not entered into until 1 March, only 10 months’ cost should be included in the statement of comprehensive income for the year ended 31 December, not the full year.
Operating lease expenses are spread on a straight-line basis over the lease term.
If the annual expense (per 12 months) is £38,750, with a 31 December year end and a 1 March starting date, the correctly calculated charge for the 10-month period is £38,750 x 10/12 = £32,292.
Year ends are not always so helpfully on 31 December, so remember to always work towards the relevant date.
ACCRUALS AND PREPAYMENTS
If there’s a difference between the accounting charge and the lease instalment paid, this is dealt with by an accrual or a prepayment.
Accruals deal with costs underpaid, to be paid later.
Prepayments deal with amounts paid in advance (prepaid).
OPERATING LEASE ASSETS
A common mistake is that people think an asset should appear on the balance sheet of the [operating lessee] company, but this is inappropriate – for an operating lease no asset or liability is recorded at the start of the lease.
DEPRECIATION LIFE
Finance-leased assets depreciate over shorter of useful life and lease term.
HOW TO SPREAD THE TOTAL FINANCE CHARGE IN A FINANCE LEASE
There are two acceptable methods for spreading the total finance charge in a finance lease. These are (1) the sum-of-digits method; and (2) the actuarial method.
IFRS 16
International Financial Reporting Standard 16 (IFRS 16) changes the lease accounting rules with effect from January 2019. Under IFRS 16 almost all leases are ‘on balance sheet’. The accounting treatment is similar to the finance lease accounting treatment described above.
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Author: Doug Williamson
Source: The Treasurer magazine