How lease accounting could work under FRS 102
On 15 December 2022, the Financial Reporting Council (FRC) issued FRED 82 Draft amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and other FRSs – Periodic Review. Comments on FRED 82 are open until 30 April 2023 and all interested parties are encouraged to send in constructive feedback on the proposals by email to ukfrsperiodicreview@frc.org.uk.
One area that has generated a lot of debate is the proposal to put leasing transactions for lessees on the balance sheet. This new accounting treatment is only proposed for FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland. FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime is unaffected by the lease accounting proposals in FRED 82 and will continue to distinguish between a finance lease and an operating lease based on the risks and rewards approach.
Exceptions to on-balance sheet lease accounting
There are exceptions proposed for short-term leases and leases of assets of low value. A short-term lease is a lease which, at the commencement date, has a lease term of 12 months or less. The value of a low-value asset is based on its value at the start of the lease; however, the FRC have not proposed a benchmark monetary amount.
In the Basis for Conclusions of IFRS® 16 Leases, paragraph BC100 states that the IASB® had in mind leases of underlying assets with a value, when new, in the order of magnitude of US$5,000 or less (it should be noted that this monetary amount is not in IFRS 16 itself).
Draft paragraph 20.9 in FRED 82 states that the assessment of the value of an underlying asset is based on the asset’s value at the commencement of the lease (this is one of the simplifications the FRC have included in developing the proposed accounting treatment). In contrast, IFRS 16, para B3 states that the assessment is based on the asset’s value when new.
To aid preparers, the FRC have provided a list of examples of underlying assets that would, and would not, typically be of low value in draft paragraphs 20.11 and 20.12 as follows:
| Assets which would typically be of low value (see draft para 20.11) | Assets which would NOT be of low value (see draft para 20.12) |
| · Tablet computers
· Personal computers · Home printers and photocopiers · Mobile phones · Desk phones · Televisions · Small items of furniture · Portable power tools |
· Cars, vans, trucks and lorries
· Cranes, excavators, loaders and bulldozers · Telehandlers and forklifts · Tractors, harvesters and related attachments · Boats and ships · Aircraft · Land and buildings |
Illustrative accounting treatment
The example below illustrates how the accounting treatment might work under the proposals. It is based on some of the principles contained in IFRS 16 which may apply in FRS 102 if the periodic review amendments are finalised as drafted:
| On 1 January 2025, Sunnie Ltd enters into a contract to lease an item of machinery for three years. The lessor agrees to maintain the machine during the lease term. The total contract cost is £210,000 and Sunnie will pay £5,833 per month (or £70,000 per annum). Sunnie accounts for non-lease components separately from lease components (see note to Step 1 below).
If contracted separately, it has been determined that the standalone price for the lease of the machine is £190,000 and the standalone price for the maintenance element is £48,000. If Sunnie were to go to its bank for an equivalent borrowing, the bank would charge an interest rate of 4%. Step 1: Allocation of the payments The annual payments of £70,000 are allocated between the lease and non-lease components of the contract based on their standalone selling prices as follows: · Lease element: (£190k / £190k + £48k) x £70k = £56,000 · Maintenance: (£48k / £190k + £48k) x £70k = £14,000 (Note draft, para 20.33 provides a practical expedient whereby a lessee may elect, by class of underlying asset, not to separate non-lease components from lease components. Instead, the lessee can account for each lease component, and any associated non-lease components, as a single lease component. Hence, if Sunnie did not have a policy of separating lease and non-lease components, the entire £70,000 would be recorded as lease payments.) Step 2: Calculate the value of the right-of-use asset and lease liability The lease liability is calculated as the present value of the minimum lease payments as follows:
There are no directly attributable costs associated with the right-of-use asset (e.g. legal fees). If there were, these would be included in the cost of the asset itself. The entries to record this transaction are as follows:
The lease liability would then be accounted for using the amortised cost method in FRS 102, Section 11 Basic Financial Instruments as follows:
At the end of 2025, the lease liability of £105,621 will be split between its current portion of £51,775 (£105,621 – £53,846) and its non-current portion of £53,846 to comply with the statutory formats of the balance sheet. Step 3: Depreciate the right-of-use asset The right-of-use asset is depreciated over its three-year lease term. This gives a depreciation charge of £51,802 (£155,405 / 3 years). |
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In the above example, as the lessor agrees to maintain the machine at its cost over the term of the lease, it could be argued that under FRS 102 (January 2022), the lease is an operating lease. Hence, lease rentals would simply be charged to profit or loss on a straight-line basis over the three-year lease term (unless another systematic basis would be more appropriate). Under the proposed lease accounting method, the lease rentals would not be charged to profit or loss and the impact can be seen as follows:
| Impact on profit or loss as at 31 December 2025 | |
| FRS 102 (January 2022) | FRS 102 proposals |
| · Lease rental expense is £70,000 | · Maintenance cost is £14,000
· Interest charge is £6,216 · Depreciation is £51,802 · Total expense is £72,018 |
| Impact on the balance sheet as at 31 December 2025 | |
| FRS 102 (January 2022) | FRS 102 proposals |
| · No impact as the lease would be an operating lease | · Asset reported of £103,603
· Liability reported of £105,621 |
You can see that the impact on profit or loss is negligible. However, there is a bigger impact on the balance sheet as the lessee is reporting an additional right-of-use asset with a net book value of £103,603 (£155,405 less depreciation of £51,802) and a corresponding lease liability of £105,621.
Tax effect of the above
HMRC are unlikely to issue guidance on the tax treatments of the above until such time that the proposals in FRED 82 are finalised. However, they did issue this Business Leasing Manual when IFRS 16 was finalised which may give some indication as to the potential tax consequences of the above.
Conclusion
The proposals for lease accounting are significant. It should be emphasised that the proposals contained in FRED 82 are not finalised and the comment period is open until 30 April 2023 so there is still time (at the time of writing this article) to submit your feedback to the FRC. Following the comment period there could be further changes made to the on-balance sheet lease accounting proposals to reflect comments received by the FRC.
Category: Accounting and standards
