Accounting for leases - part 2

1 What are the problems with the current accounting treatment of leases?
At present, all across the world for accounting purposes, all leases are classified into finance and operating leases. A finance lease is one where the risks and rewards of ownership are deemed to have passed to the lessee. All other leases are operating leases. Finance leases are accounted for by the lessee as if the lessee has taken out a loan to buy an asset, whereas operating leases are expensed to the profit and loss account. Many lessees will prefer to account for a lease as an operating lease because no liability has to be recognised on the balance sheet. Two problems flow from this:

• Firstly in the classification of a lease as either a finance lease or an operating lease all too often “the 90% test” is taken as a rule in determining whether risks and rewards have passed, and this allows scope for creative accounting.

Creative accounting and the 90% test
All too often “the 90% test” is taken as a rule in deciding whether the risks and rewards of ownership have passed but the calculation of the 90% is not objective. The 90% test is that a lease is presumed to be a finance lease if at the inception of the lease the present value of the minimum lease payments amounts to substantially all (i.e., 90%) of the fair value of the leased asset. The present value rate to discount the cash flows should be the interest rate implicit in the lease, after all the substance of a finance lease is a loan. The rate of interest implicit in the lease is the discount rate which when applied to what the lessor expects to receive and retain gives the fair value of the leased asset.

If the unguaranteed estimated residual value accruing to the lessor (i.e., the expected scrap value of the asset at the end of its lease term) is nil, then the present value of the minimum lease payments must be 100% of the fair value of the asset. For the lessor any guaranteed residual amount accruing will be included in the minimum lease payments.

It can therefore be seen whether or not a lease is classified as a finance lease, can hinge on the estimate of the unguaranteed residual amount accruing to the lessor. It is conceivable that a lessor could be persuaded by a lessee to estimate a larger residual amount to cause the lease to fail the 90% test and thus enable the lessee, not to account for the liabilities on its balance sheet.

There is another creative accounting possibility when the lessee is unaware of the interest rate implicit in the lease and is unable to calculate it because he does not know the lessors estimate of the unguaranteed residual amount at the end of the lease. In these circumstances, the lessee has to provide his own estimate and could therefore estimate a residual amount which causes the lease to fail the 90% test.

• Secondly the accounting for long non-cancellable operating leases amounts to off balance sheet finance.

Operating leases as off balance sheet liabilities
I think the best way to understand this is to consider the following exercise to illustrate the point.

It is necessary to judge whether the lessee has obtained the risks and rewards of ownership of the asset i.e., whether it is a finance lease.

At the end of the lease the lessee has the right to buy the car at an agreed market price. Accordingly the lessee does not have any access to future economic benefits, if the car is in good condition with a low mileage and therefore has a high second hand value then the lessee will have to pay more for the car. This clause suggests that it is an operating lease.

Further, experience shows that an asset such as a motor car has a life well in excess of three years. Because the lease period is not for substantially the whole of the asset’s life this again points to the lease being an operating lease as there will be a material residual value accruing to the lessor at the end of the lease period.

Whilst no implied rate of interest has been given it is possible to do a rough 90% test. Remember that a lease is presumed to be a finance lease at the inception of the lease the present value of the minimum lease payments amount to substantially all (i.e., 90%) of the fair value of the leased asset. In this exercise the minimum lease payments before discounting are only 75% of cash price (fair value) of the asset. Discounting the minimum lease payments would only reduce the percentage further. This is powerful evidence that the lease in question is an operating lease.

Minimum lease payments (3 x £5,000 = £15,000) = 75%
Fair value of the asset                 20,000

As an operating lease the lessee will charge the £5,000 lease rental as an expense to each year’s profit and loss account. No asset or liability will be recorded on the balance sheet. Disclosure in the notes will be made that an operating lease rental of £5,000 has been made and that at the year end there are commitments to make the future lease payments, i.e., at the end of the first year there is a commitment to pay £10,000 over two years, and at the end of year two there is a commitment to pay £5,000 in the next period.

(ii) Critically comment on the accounting treatment required and suggest an alternative approach.

An alternative approach is to abandon the distinction between finance and operating leases altogether as it is arbitrary and, as in this example, results in off balance sheet finance.

It can be strongly argued that the current accounting treatment for this operating lease understates the reported liabilities of the lessee. At the end of the first year the commitment to pay £10,000 surely represents an actual liability. After all the Accounting Standards Board’s (the ASB) Statement of Principles definition of a liability is an obligation to transfer economic benefits as a result of past transactions or events. It can also be argued that the lessee does have an asset in that under the terms of the lease the lessee controls the asset and has access to the economic benefits of the asset over the next two years. At the end of the first year of the lease the lessee’s asset and liability could be measured at the present value of £10,000 to reflect the time value of money. It is a common and growing practice of analysts to recast financial statements on this basis which begs the question why the financial statements do not reflect this in the first place.

On 16 December 1999 the ASB published a Discussion Paper entitled ‘Leases: Implementation of a New Approach’ which suggested this approach. This discussion paper originates from an agreed approach that has been developed by the G4+1 international group of accounting standard-setters.

2 The current proposals for change
The G4 + 1

Having looked at the reasons for changing the accounting treatment for leases let us look at the actual proposals in a bit more detail.

As we are now aware the change has been discussed at an international level which potentially has the real benefit of harmonising international accounting. But what is the G4+1? The G4+1 comprises members of the standard-setting bodies from Australia, Canada, New Zealand, the UK and the USA. Representatives of the International Accounting Standards Committee attend as observers. The G4+1 organisations aim to share their ideas and approaches to standard setting problems. By pooling their resources and by co-operation better financial reporting standards should emerge as well as the convergence of financial reporting standards across member jurisdictions.

Discussion paper ‘Leases: Implementation of a New Approach’
SSAP 21, Accounting for leases and hire purchase contracts, IAS 17, Accounting for Leases (Revised 1999), HKSSAP 15, Accounting for Leases, and SAS 15, Accounting for Leases, all require the same radically different accounting treatment (both in the lessee’s and the lessor’s financial statements) for transactions classified as finance leases and those classified as operating leases. The distinction between operating leases and finance leases that is required by present standards is arbitrary and unsatisfactory. The main deficiency of these standards is that they do not provide for the recognition in lessees’ balance sheets of material assets and liabilities arising from operating leases.

How leases are classified has important implications, for example, for reported levels of indebtedness, gearing ratios, return on assets employed and interest cover. It is argued that the comparability (and hence usefulness) of financial statements would be enhanced if the present treatment of operating leases and finance leases were replaced by an approach that applied the same requirements to all leases.

The discussion paper explores the principles that should determine the extent of the assets and liabilities that lessees and lessors would recognise under leases, and how those principles might be applied in a new accounting standard to account for many of the complex features (such as options, contingent rentals and residual value guarantees) that are found in lease contracts. The main recommendations are as follows:

• For lessees, the objective should be to record, at the beginning of the lease term, the fair value of the rights and obligations that are conveyed by the lease.
• Leases that are at present characterised as operating leases (and therefore not included in the balance sheet) would give rise to assets and liabilities, but only to the extent of the fair values of the rights and obligations that are conveyed by the lease. Thus, where a lease is for a small part of an asset’s economic life, only that part would be reflected in the lessee’s balance sheet.
• The fair value of the rights obtained by a lessee would in general be measured as the present value of the minimum payments required by the lease, plus any other liabilities incurred.
• Lessors should report financial assets (representing amounts receivable from the lessee) and residual interests as separate assets, since they are subject to quite different risks. The amounts reported as financial assets by lessors would, in general, be the converse of the amounts reported as liabilities by lessees.

The ASB has noted certain issues that are likely to be regarded as particularly significant in the UK:

• the accounting that should be required in relation to buildings that are held on long leases with features that are common in the UK but not in other countries represented in the G4+1;
• the future accounting for investment properties that are stated at fair value, in accordance with the requirements of SSAP 19, Accounting for investment properties, — the ASB agrees that the requirement to give information on current values should be preserved;
• the method by which lessors should recognise income from leases. An Appendix discusses the arguments for and against the main types of methods that are used — net investment (as required by the IAS 17, Accounting for Leases,(Revised 1999)) and net cash investment (as required by SSAP 21) — but does not reach any consensus on which method should be required. The ASB’s view is that the net cash investment method more faithfully reflects the economic realities of leases.

3 Other leasing issues
There are some other aspects of leasing worth considering as well:

(a) Sale and lease-back arrangements
It is possible for an entity to sell an asset but still retain the use of it by means of a back to back arrangement to lease it back again. This is known as a sale and lease-back arrangement. When accounting for such transactions it is necessary to consider the substance of the arrangement i.e., FRS 5, Reporting the Substance of Transactions.

(i) Sale with a finance lease-back
When an entity sells an asset but retains possession of the asset by entering into a finance lease-back ,although it has given up legal title to the asset by the very nature of the finance lease arrangement, it immediately reacquires the risks and rewards of ownership. In such circumstances there has not been in substance a sale. This transaction represents a secured loan and should be accounted for accordingly. No profit can be reported and the “sale proceeds” are accounted for as a liability. The finance lease rentals are accounted for partly as a capital repayment of the loan and partly as a finance charge in the profit and loss account.

(ii) Sale at a fair value with an operating lease-back
When an entity sells an asset at its fair value but retains possession of the asset by entering into an operating lease back then there is harmony between economic substance and legal form. The risks and rewards of ownership have passed away and have not been reacquired. The sale is really a sale and the profit or loss on the transaction is recognised immediately. The asset is derecognised and the operating lease rentals expensed in the profit and loss account.

(iii) Sale at an undervalue with an operating lease-back
Because the nature of the lease-back is an operating lease, there really has been a sale and the asset is derecognised. However one has to ask why the asset is being sold at undervalue? It may be that the entity was so in need of cash that it struck a bad bargain just to raise the money. In which case the loss on the disposal is recognised immediately. Alternatively the reason for the sale at below value may be connected with the terms of the lease-back payments which may also be at below value. In these circumstances it is appropriate to spread the loss forward over the period of the lease (or until the next rent review) to match with the low lease rentals.

(iv) Sale at an over value and with an operating lease-back
Because the nature of the lease-back is an operating lease there really has been a sale and the asset is derecognised. The profit on the disposal of the asset must be restricted to the difference between the fair value of the asset and its carrying value. However, one has to ask why the asset is being sold at over value? It may be connected with the terms of the lease-back which requires that the lease rentals be at over value. In these circumstances the excess profit is spread forward over the period of the lease (or until the next rent review) to match the excessive rentals. What is more likely though is that the excessive sale proceeds really represents two transactions, a sale of the asset at the fair value and the receipt of a loan. In which case the liability to repay the loan needs to be immediately recognised. The lease rentals will then have to be accounted for as partly an operating expense (the rental of the asset), partly the capital repayment of the loan and partly the finance charge on the loan.

(b) Lessor accounting for finance leases
To reflect the substance of the finance lease, the lessor accounts for having made a loan and does not account for the leased asset it legally owns. The present value of the minimum lease payments are shown as a debtor (the net investment in the lease) and split between current and long term debtor. Interest receivable is recorded in the profit and loss account as turnover (if leasing is a major part of the business), or as interest receivable (if leasing is a minor part of the business).

IAS 17 requires the total income receivable be allocated over the period of the lease to give a constant rate of interest on the net investment. Whereas in the UK SSAP 21 requires the total income receivable be allocated over the period of the lease to give a constant rate of interest on the net cash investment. The lessor’s net cash investment in the lease is different from the net investment, as the net cash investment considers all the cash flows associated with the lease e.g, tax.

(c) UITF Abstract 12:Lessee accounting for reverse premiums and similar incentives
Arrangements regarding an operating lease may include incentives for the lessee to sign the lease. Such incentives may take various forms, such as an up-front cash payment to the lessee (a reverse premium), a rent-free period or a contribution to certain lessee costs (such as fitting out or relocation), but are not limited to these examples. The question arises as to how such incentives should be accounted for in the accounts of the lessee.

The UITF consensus is that, whatever form they may take, benefits received and receivable by a lessee, as an incentive to sign the lease, should be spread by the lessee on a straight-line basis over the lease term or, if shorter than the full lease term, over the period to the review date on which the rent is first expected to be adjusted to the prevailing market rate. Where, exceptionally, the presumption can be rebutted that an incentive (however structured) is in substance part of the lessor’s market return another systematic and rational basis may be used, with disclosure of the following:

1. an explanation of the specific circumstances that render the standard treatment specified by this Abstract misleading;
2. a description of the basis used and the amounts involved; and
3. a note of the effect on the results for the current and corresponding period of any departure from the standard treatment.