FRS 102: Understanding Accounting for Lease Agreements

At Mercia, we receive lots of queries on the accounting for personal contract purchase (PCP), hire purchase (HP) agreement and contract hire arrangements.

In this blog, we go back to basics to consider the accounting treatments under FRS 102.

Introduction

FRS 102 defines a lease as:

An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

Whether an arrangement is called a personal contract purchase, a hire purchase agreement, contract hire, or something else entirely, all of these such arrangements will usually meet the definition of a lease and the accounting for them will therefore be dictated by Section 20 of FRS 102.

FRS 102 makes no distinction between these types of arrangements – a lease is either an operating lease or a finance lease – when considering the accounting at least, it does not therefore matter what label has been put on the arrangement.

Operating lease or finance lease?

The definitions of operating and finance lease are relatively simple - 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 reward incidental to ownership. Making the determination can be more subjective.

Every arrangement will need to be assessed based on its own merits, however FRS 102 includes examples of situations that individually, or in combination would normally lead to the lease being classified as a finance lease:

• the lease transfers ownership of the asset to the lessee by the end of the lease term;
• the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
• the lease term is for the major part of the economic life of the asset even if title is not transferred;
• at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and
• the leased assets are of such a specialised nature that only the lessee can use them without major modifications.

FRS 102 also includes indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease:

• if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
• gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee (eg in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and
• the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.

A careful consideration of all the terms of the arrangement will be needed when making the determination as to whether the lease is a finance or operating lease. These considerations should be documented, with particular focus being placed on the key judgements and assumptions made as part of the determination.

Operating leases

In broad terms, a lessee in an operating lease arrangement will usually need to spread the rentals on a straight-line basis over the lease term. The asset being leased will not be capitalised on the balance sheet.

Finance leases

In broad terms, a lessee in a finance lease arrangement will usually need to bring its rights and obligations under the finance lease onto the balance sheet. The finance lease liability will then be accounted for using the effective interest method (i.e. building up with interest and being reduced with payments made to the lessor). The leased asset will be depreciated over its useful life.

Summary

When considering leasing arrangements, don’t be distracted by the label put on them – instead carefully review the terms of the arrangement, follow usual accounting principles to establish whether it is an operating or finance lease, and account for it accordingly.

A word of warning

The FRC is currently considering responses to FRED 82, the periodic review of FRS 102. This proposed significant changes to leasing under FRS 102. We are currently awaiting the final pronouncement and will provide further guidance on the changes once these have been finalised by the FRC.

How can Mercia help?

Mercia offers a range of training courses and offers a comprehensive technical query service for advice on your specific circumstances.