Lessee Accounting Treatment under FRS 17
The FRS 17 Leases must be complied with in accounting for leases. This standard includes the accounting requirement for operating and finance leases and other related agreements such as property leases and sale and leaseback agreement.
The starting point with lease accounting is to determine whether the transaction meets the definition of a lease. Thereafter, the lease must be classified either as a finance lease or an operating lease according to the substance of the agreement.
In determining the substance of a lease agreement, it is important to firstly identify all the relevant facts set out in the agreement and thereafter judgement must be exercised to assess which party (the company or the lessor) has the risks and rewards of ownership.
Risks include the possibility of losses arising from breakdown, idle capacity, technological obsolescence and falls in value due to changing economic conditions.
Rewards include potential gains arising from profitable use of the asset over its economic life and future sale of the asset where it has increased in value.
Under FRS 17 paragraph 20, a lessee is to recognise finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased asset or, if lower, the present value of the minimum lease payments.
FRS 17 defines a finance lease as a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred; and an operating lease as a lease other than a finance lease.
From these definitions, you can see that the classification of a lease is based on the extent to which the risks and rewards of ownership lie with the legal owner, the lessor, or are transferred to the user, the lessee. If a lease transfers substantially all the risks and rewards of ownership of an asset to the lessee, it should be classified as a finance lease. All other leases should be classified as operating leases.
Examples of situations that individually or in combination would result in the classification of a finance lease:
- the lease transfers ownership of the asset to the lessee by the end of the lease term
- the lease provides for a bargain option for lessee to purchase the asset at such a price that it is reasonably certain from the outset that the option will be exercised
- the lease term is for the major part of the economic life of the asset even if legal title is never 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 (>90%), and
- the leased assets are of such a specialised nature that only the lessee can use them without major modifications.
FRS 17 is silent on the threshold of the terms “major part” and “substantially all”, although other GAAPs may state so. When applying FRS 17, it is important to consider the economic substance of the lease agreement.
Other indicators of situations that would result in the classification of a finance lease are:
- the lessor’s losses associated with the cancellation are borne by the lessee
- gains or losses from the fluctuations in fair value of the residual at the end of the lease accrue to the lessee
- the lessee has the option to extend the lease for a secondary period at a nominal rent.
When a lease includes both land and building elements, an entity assesses the classification of each element as finance or operating lease separately in accordance with FRS 17 paragraphs 7 to 13.
In the determination of whether the land should be classified as a finance or operating lease, it is important to consider that land normally has an indefinite useful life.
Lessee Accounting Treatment under FRS 116
Under FRS 116, lessees do not distinguish between a finance lease and an operating lease. Therefore, for the majority of lease contracts the lessee recognises a lease liability reflecting future lease payments and a “right-of-use” asset.
This new model is based on the rationale that economically a lease contract is equal to acquiring the right to use an asset with the purchase price paid under instalments. Lessees will recognise interest expense on the lease liability and a depreciation charge on the “right-of-use” asset.
In comparison to the prior accounting requirements for operating leases under FRS 17, this will change the presentation in the income statement as well as the total expense recognised in each period:
(1) the straight-line depreciation of the right-of-use asset and
(2) the application of the effective interest rate method to the lease liability
(1) and (2) will be the total charge to profit or loss in the initial years, and decreasing expenses during the latter part of the lease term.
The cash flow statement will also be impacted as lease payments that were previously classified as operating leases will no longer be included within the operating cash flow section.
Instead, lease payments will be separated to reflect the repayment of the principal portion of the lease liability under ‘financing activities’ while the interest expense will be reported in either ‘operating activities’ or ‘financing activities’.
Payments for short-term leases, for leases of low-value assets and variable lease payments not included in the measurement of the lease liability will be reported as operating activities.
The effective date and transition of FRS 116 is applicable for annual reporting periods beginning on or after 1 January 2019. Earlier application is permitted if FRS 115 has bee applied.
The lessee shall either apply FRS 116 with full retrospective effect, or alternatively not restate comparative information, but recognise the cumulative effect of initially applying FRS 116 as an adjustment to opening equity at the date of initial application.
FRS 116’s definition of a lease focuses on the concept of control. The important question is:
- Does the company have control over the asset over the lease term?
- Can the company obtain the economic benefits from the asset?
If the answers are yes, then the company has what is called a ‘right-of-use asset’ which must be recognised in the company’s financial statements.
Under FRS 116 paragraph 26, a lessee shall measure the lease liability at the present value of the lease payments. FRS 116 paragraph 27 goes on to define lease payments to include the amounts expected to be payable by the lessee under residual value guarantees.
There are 2 significant differences when computing lease liability under FRS 17 and FRS 116:
- A lessee no longer considers the maximum amount that could become payable, but just the amount expected to be payable under residual value guarantees, and the lessee is also required to re-measure the lease liability if there are changes in amounts expected to be payable under the residual value guarantees.
- The residual value guarantees by a party related to the lessee is included in the computation of lease liability under FRS 17, only residual value guarantees by the lessee is included under FRS 116.
Therefore, all else being the same, under FRS 116, the amount recognised as lease liability will not be more than that recognised under FRS 17. Consequently, the amount recognised as the right-of-use asset under FRS 116 would also be smaller than that of the leased asset recognised under FRS 17.
Therefore, the different in definition of lease payments between FRS 17 and FRS 116 would results in the differential treatment of residual value guarantees and the computation of lease liability and asset. Although such impact is likely to be immaterial.
The requirement to re-measured lease liability and right-of-use asset under FRS 116 due to changes to the expected amount payable under residual value guarantees will result in subsequent recognition of total lease expenses that are higher than those under FRS 17 (which does not require re-measurement) for each of the affected financial year.
Exemptions
As it might be perceived burdensome for some companies to be recognising ‘right-of-use’ assets and lease liabilities for all leases, FRS 116 provides certain recognition exemptions to leases that are not considered significant (low value assets – about USD5,000 or less) or have a lease term of less than 12 months. In such cases, the payments made in accordance with the contract are expensed when incurred.
FRS 116 states that instead of applying the recognition requirements of FRS 116, a company may elect to account for lease payments as an expense on a straight-line basis over the lease term or another systematic basis for the following 2 types of leases:
- Leases with a lease term of 12 months or less and containing no purchase options – this election is made by class of underlying assets; and
- Leases where the underlying asset has a low value when new (such as personal computers or small items of office furniture) – this election can be made on a lease-by-lease basis.
For some examples of leases of low value assets and portfolio application, kindly refer to FRS 116 Leases Illustrative Examples (FRS 116 IE) and Amendments to Guidance on other Standards.
It may be well appreciate from those examples indicated in FRS 116 IE that a lease of office equipment which includes high-capacity multi-function photocopier devices will not be considered as low value assets.
Source: IFRS, 13 June 2018