In Chapter 2 we discussed the accounting principle of substance over form. This says that if the company has the benefits and risks associated with owning an asset, the asset should be incorporated into the accounts, regardless of the legal position. This is now embodied in the accounting standards (SSAP 21, Accounting for Leases and Hire-Purchase Contractsand FRS 5, Accounting for the Substance of Transactions), and has a large impact on the tangible fixed assets that are shown on the balance sheet.
The assets will be shown, regardless of the legal ownership, if the company has access to the benefits and the risks of owning the asset. Assets purchased under hire-purchase agree- ments will be included as fixed assets, even though the company does not own the asset until it has met certain conditions (normally when it has paid the final instalment). Assets leased on long-term leases where the company has all the benefits of ownership (finance leases) will also appear as part of the tangible assets. Whereas those leased on a short-term basis giving none of the benefits of ownership (operating leases) will not, and their lease rentals will be charged to the profit and loss account.
The accounting standard (SSAP 21, Accounting for Leases and Hire-Purchase Contracts) defines these two types of leases and the appropriate accounting treatment for them.
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Finance leases
SSAP 21, in its introductory notes, recognises that it may be difficult to define precisely the dif- ference between a finance lease and an operating lease. It states that a finance lease is one that
‘transfers substantially all the risks and rewards of ownership to the lessee’. The difference between the two types of leases is largely one of degree, not of any fundamental difference.
However, the accounting standard does give a primary test for a finance lease, which is:
● the present value of the lease payments is at least 90 per cent of the fair value of the leased asset;
● the present value will be calculated using the interest rate implicit in the lease and is the discount rate where the present value equals the fair value of the asset. (If any of these terms are unfamiliar, they are explained in detail in Appendix I on discounted cash flow.) Accounting treatment
There are two types of companies that are involved in leasing – the lessees(who lease and use the asset, but do not legally own it) and the lessors(who own the asset and lease it to another company).
Most companies are lessees, so we will consider the accounting treatment for lessees in more detail than that of lessors.
Lessee
The basic principle is that both the asset and the underlying liability should be shown on the balance sheet. Therefore, assets leased under finance leases are capitalised and depreci- ated over their life. (The life must be the shorter of the lease term and the anticipated useful life.) The lease rentals are then split between the interest element and the capital element.
Interest will be charged to the profit and loss account in the normal way. The capital amount owed to the leasing company is included in creditors, and any capital repayments will reduce the amount owed to the leasing company.
The allocation between capital and interest payments is not as straightforward as it sounds, as the standard requires companies to use present-value techniques to determine the split. There are three accounting methods that can be used to calculate the charge to the pro- fit and loss account and the remaining leasing liability shown on the balance sheet that are illustrated in SSAP 20. These are:
(1) the actuarial method, also known as the implicit interest-rate method;
(2) the sum-of-the-digits method, also known as the Rule of 78 (this name arose because if finance charges were allocated over a one-year period, the sum of months one to 12 add up to 78).
(3) the straight-line method.
The different methods are illustrated through the use of the example below.
A company buys a machine on a ten-year finance lease, with an option to extend the lease for a further five years. The first payment of £10 000 is made on the delivery of the machine, and the remaining payments of £10 000 per annum are made annually in advance. The machine cost the finance company £67 590 to buy and this gives an approximate implied interest rate of 10 per cent (the present value £10 000 per annum for ten years, at 10 per cent, is £67 590.24). The machine is expected to last for ten years, and have no residual value.
Payment date Present value of £1 Present value of £10 000 on the payment date
On delivery in year 1 1.000 10 000
Year 2 0.909 9 090
Year 3 0.826 8 260
Year 4 0.751 7 510
Year 5 0.683 6 830
Year 6 0.621 6 210
Year 7 0.565 5 650
Year 8 0.513 5 130
Year 9 0.467 4 670
Year 10 0.424 n4 240
67 590
The machine will be shown as a fixed asset with a value of £67 590, which will be the same as the creditor. Therefore, the recognition of the fixed asset will have no initial impact on the com- pany’s net worth. The machine will be depreciated on a straight-line basis over ten years, as this is shorter than the lease term (a possible 15 years) and the anticipated useful life (ten years). Con- sequently, the depreciation charge will be £6759 a year.
The actuarial method
At the end of the first year the machine will be worth £60 831 (67 590 – 6759).
To find out the value of the creditor at the end of the first year, it is necessary to recalculate the present value of the outstanding payments. There are only nine years of payments remaining, so the present value can be simply calculated as £67 590 – £4240 = £63 350.
The lease rental must now be split between the capital repayment and the interest charge.
£10 000 has been paid as a lease rental, £4240 is the capital repayment that has been deducted from the liability. The balance of £5760 is regarded as interest, and is charged to the profit and loss account. Consequently the impact on the profit and loss account and the balance sheet will be as shown in Table 8.3.
8 Ownership of assets
EXAMPLE
EXAMPLE
If we add together our interest charge of £32 410 and the depreciation charge (asset value) of
£67 590 we have the total lease payments of £100 000.
The same split between the capital and the interest can be identified by using a slightly differ- ent basis for the calculation as shown in Table 8.4.
You will see that there are some small rounding differences, but whilst the logic is differ- ent the numbers remain essentially the same.
The sum-of-the-digits method
Another way of calculating the interest charge, and the corresponding leasing liability, is to use the sum of the digits, which is an approximation to the actuarial method. It is based on the depreciation formula that we discussed earlier in the chapter.
First, we need to calculate the number of lease payment periods (the number of periods Identifying the capital/interest split
Table 8.4
Liability at the Payment made Remaining Interest on the Total creditor – beginning of the at the beginning liability after the remaining liability carried
year of the year payment liability @ 10% forward at the
end of the year
Year 1 67 590 10 000 57 590 5 759 63 349
Year 2 63 349 10 000 53 349 5 335 58 684
Year 3 58 684 10 000 48 684 4 868 53 552
Year 4 53 552 10 000 43 552 4 355 47 908
Year 5 47 908 10 000 37 908 3 791 41 698
Year 6 41 698 10 000 31 698 3 170 34 868
Year 7 34 868 10 000 24 868 2 487 27 355
Year 8 27 355 10 000 17 355 1 735 19 090
Year 9 19 090 10 000 9 090 909 9 999
Year 10 9 999 10 000 (1) (0) (1)
Total 32 409
Split between capital and interest: impact of lease rental Table 8.3
Balance sheet Profit and loss account
Fixed-asset value Total creditor – Interest charge Depreciation charge
End of: remaining lease
payments
Year 1 60 831 63 350 5 760 6 759
Year 2 54 072 58 680 5 330 6 759
Year 3 47 313 53 550 4 870 6 759
Year 4 40 554 47 900 4 350 6 759
Year 5 33 795 41 690 3 790 6 759
Year 6 27 036 34 860 3 170 6 759
Year 7 20 277 27 350 2 490 6 759
Year 8 13 518 19 090 1 740 6 759
Year 9 6 759 10 000 910 6 759
Year 10 0 0 0 6 759
Total 32 410 67 590
between the beginning of the lease and the last payment). This is the number of periods over which interest accrues, and in our example it is nine. (This is because our payments are made in advance, if they had been in arrears it would have been ten.)
The formula for the sum of the digits is:
n(n + 1) 2
We have calculated that n= 9 and so we have a value of 45 (90/2 = 45). The total interest paid over the period of the lease is £32 410 and this now has to be charged to each period of the lease.
The straight-line method
This is the simplest method and works in the same way as that discussed in depreciation. The total interest charge of £32 410 is allocated equally to each year, giving an annual interest charge of £3241.
8 Ownership of assets
EXAMPLE
EXAMPLE
The capital/interest split: sum of the digits Table 8.5
Profit and loss Balance sheet account
Liability at the Payment made Sum-of-the- Interest charge Total creditor – beginning of the at the beginning digits formula for the year liability carried
year of the year used for the forward at the
interest end of the year
Year 1 67 590 10 000 9/45 x 32 410 6 482 64 072
Year 2 64 072 10 000 8/45 x 32 410 5 762 59 834
Year 3 59 834 10 000 7/45 x 32 410 5 042 54 875
Year 4 54 875 10 000 6/45 x 32 410 4 321 49 197
Year 5 49 197 10 000 5/45 x 32 410 3 601 42 798
Year 6 42 798 10 000 4/45 x 32 410 2 881 35 679
Year 7 35 679 10 000 3/45 x 32 410 2 161 27 839
Year 8 27 839 10 000 2/45 x 32 410 1 440 19 280
Year 9 19 280 10 000 1/45 x 32 410 720 10 000
Year 10 10 000 10 000 0 10 000
Total 32 410
The actuarial method and the sum-of-the-digits method give very similar results; whereas the straight-line method gives a comparatively lower charge in the earlier years and a higher charge in the later years. This is shown by Figure 8.2.
SUMMARY
Lessors
So far we have assumed that the company we are analysing is the one that is leasing the asset from the finance company – the lessee. If the company we were analysing was the finance company (the lessor), the accounting treatment would be different.
The lessor legally owns the asset, but passes all the risks and rewards of ownership to the lessee in exchange for a stream of rentals. Thus, essentially the lessor is providing finance and expects a return on that finance. In consequence, the finance lease is accounted for as a loan, not as a fixed asset. The lessor records the amounts due from the lessee as a debtor. This debtor reflects the net investment in the lease, which will usually be the cost of the asset less:
● any government or similar grants that have been received; and
● provisions for any bad and doubtful debts.
If the asset has a residual value, this will be shown on the balance sheet at the end of the lease.
The standard requires that the lease rentals should be split between the interest earned (the gross earnings), and repayment of the capital. Whilst the debtor is based on the lessor’s net investment in the leased asset, the income taken in the profit and loss account will be deter- mined by a different figure. Income should be allocated to accounting periods based on the net cash investmentof the lease. This is the amount of money that the lessor has tied up in the lease. It takes account of other factors (for example, taxation and interest on any bor- rowings used to finance the purchase of the asset, profit taken out of the lease). The gross earnings in each period are then allocated to accounting periods to give a constant return on the lessor’s net cash investment in the asset.
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Disclosure requirements
Both lessors and lessees have to disclose information about their finance-leased assets, and the detailed disclosure requirements are discussed below.
INTEREST CHARGED TO THE PROFIT AND LOSS ACCOUNT Figure 8.2
Interest charge Thousands
0 1 3 4 5
2
Straight line Actuarial
Year
Sum of the digits 6
1 2 3 4 5
7
6 7 8 9 10
8 Ownership of assets
Lessees
Companies should disclose the accounting policy adopted for finance leases, the value of the leased assets and the obligations to the leasing company. Any leases entered into before the balance sheet date, but which have not yet started, should also be disclosed.
The disclosure of assets held under finance leases may be given in one of two ways:
(1) summarised disclosure:the company can combine the owned and leased assets, dis- closing the net book value of assets held under finance leases, together with the related depreciation. This is the most common form of disclosure;
(2) detailed analysis: the company may show the gross amounts of assets held under finance leases and the related total depreciation. This should be given for each major class of asset.
The capital obligations under any finance lease should be disclosed in the accounts, split between creditors due within a year, and more than a year.
Lessors
Lessors will need to disclose:
● the accounting policy adopted for finance leases;
● the net investment, in finance leases, split between that due within a year and more than a year;
● the total rents receivable from finance leases during the period;
● the cost of assets acquired for use in finance leases.
The accounting treatment for finance leases follows the accounting principle of substance over form, therefore the party that has all the risks and rewards of ownership shows the asset in their accounts. The interest and the capital repayment should be accounted for separately, with interest being reflected in the profit and loss account, and the capital element shown on the balance sheet. Accounting policies and details of leased assets should be shown in the accounts.
Lessors
The legal owner of the asset, the lessor, will not show the asset on his balance sheet.
Instead, the lessor will show a debtor, representing the net investment in the asset, which is analysed between amounts falling due within a year and in more than a year. The lessor must calculate two investment figures:
(1) the net investment in the asset. This is used for the valuation of the debtor shown on the balance sheet; and
(2) the net cash investment in the asset. This is the amount of money the lessor has tied up in the lease, and is used for the calculation of gross earnings.
The earnings in each period are calculated to give a constant return on the lessor’s net cash investment in the asset.
Lessees
Both the asset and the underlying liability should be shown on the balance sheet. The asset should be depreciated over the shorter of the lease term and the anticipated useful life. The lease rentals are then split between interest and the capital repayment; this is SUMMARY
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INTERNATIONAL DIFFERENCES International accounting standards
IAS 17 (Leases), revised in 1997, has a looser definition of a finance lease than SSAP 21, defining it simply as one that transfers substantially all the risks and rewards of ownership.
The asset is shown at the lower of the fair value and the present value of the minimum lease payments and is depreciated over the asset’s useful life, if it is reasonably certain that the lessee will own the asset by the end of the lease term. Otherwise the asset is depreciated over the shorter of the lease term or the useful life.
Europe
Within Europe, finance leases may be capitalised, but this practice is less common than in the UK. In the Netherlands finance leases are capitalised, and in France finance leases may be capitalised in the group accounts. In Germany they are also capitalised, but the definition is related to tax rules and most leases are designed to avoid capitalisation.
Japan
Japanese practice is similar to the German, as both countries concentrate on the legal sub- stance and the tax basis rather than commercial substance. The capitalisation of finance leases is allowed, but is unusual. When leases are not capitalised, the number and descrip- tion of the assets would be given in the supporting schedules.
North America
There are four criteria for identifying finance leases (capital leases) in the USA:
(1) the lease transfers ownership to the lessee (2) the lease contains a bargain purchase option
(3) the lease term covers 75 per cent of the remaining economic life of the asset (4) the present value is 90 per cent or more of the asset’s fair value.
Canadian practice has been influenced by the USA. Leases are capitalised if:
● there is reasonable certainty that ownership will be transferred
● the lease term covers 75 per cent of the remaining economic life of the asset
● the present value is 90 per cent or more of the asset’s fair value.
These percentages are only guidelines, and leases can be capitalised even though the per- centage criteria are not met.
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Operating leases
An operating lease is any ‘lease other than a finance lease’.
determined by present-value techniques. The total interest must be allocated to the pro- fit and loss account, usually by using one of three different methods:
● the actuarial method
● the sum-of-the-digits method
● the straight-line method.
Both the actuarial method and the sum-of-the-digits method give very similar results.
The capital amount owed to the leasing company is included in creditors, which is split between amounts falling due within a year and in more than a year.
8 Ownership of assets
Accounting treatment
Operating leases are treated in the same way as any other short-term hire agreement. The lease rental is charged to the profit and loss account as an operating cost. Neither the asset, nor the commitment to the leasing company is shown on the balance sheet. Consequently, operating leases can be regarded as ‘off balance-sheet financing’. The lease rental is charged to the profit and loss account on a straight-line basis, unless another method is more approp- riate. UITF 12 (Lessee Accounting for Reverse Premiums and Similar Incentives) states that incen- tives received should be spread over the lease term or, under some circumstances, a shorter period.
Disclosure
The notes to the profit and loss account will disclose the amount charged during the period, split between the hire of plant and machinery and other assets. As the leasing agreement rep- resents a contingent liability, the notes on contingent liabilities will disclose the annual commitment for operating leases. These will be analysed between:
● leases expiring in one year
● leases expiring between two and five years
● leases expiring in more than five years.
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A thought on leases
Whether a lease is a finance lease or an operating lease is clearly important. The accounting standard tries to define the differences between the two, but stresses that it can only be a matter of degree. The standard recognises that it is often difficult to decide whether the lease is a finance or an operating lease. This grey area has allowed finance companies to try and develop finance leases that can be classified as operating leases under the standard. However since FRS 5, the opportunities for off balance-sheet funding through leases has been limited.
If the company has the liability associated with ownership, it will be required to show both the asset and the associated liability on the balance sheet.
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Hire-purchase agreements
SSAP 21 defines a hire-purchase contract as one which is for the hire of an asset, where the own- ership of that asset transfers to the hirer when he has fulfilled certain conditions. (This is dif- ferent from a credit-sale agreement where the ownership of the asset passes immediately and consequently ownership is not separated from the risks and rewards associated with the asset.) Hire-purchase agreements are accounted for in a similar way to leases, the only real dif- ference being that the hire-purchase company allocates income on the net investment in the contract (rather than the net cash investment).
Operating lease rentals are charged to the profit and loss account on a straight-line basis.
The note on contingent liabilities will disclose the agreed annual rentals that have been taken off the balance sheet.
SUMMARY