3.1.1 Licensing agreements

FRS 102 does not define a licensing agreement so the distinction between ‘leases’ and ‘licensing agreements’ is not clear.

A conventional licence over an intangible asset such as a film or video commonly gives a non-exclusive ‘right of access’ to show or view the video simultaneously with many others but not a ‘right of use’ of the original film or video itself because the licensee does not control that asset. Arguably, this puts such a conventional licence outside the scope of Section 20. The relationship between rights of access to and rights of use over the underlying asset is explored further at 3.2 below.

Intangible assets themselves may be the subject of leases, as discussed below.

3.1.2 Arrangements over intangible assets

Section 20 applies to leases over intangible assets although there are additional issues when the right is not tangible.

First, the ‘right’ in question must be an asset that meets the definition of an intangible asset in Section 18 – Intangible Assets other than Goodwill – (see Chapter 16). Second, because many of these rights are either acquired for an up-front sum or for a series of periodic payments and by definition the period covered by the payments equals the life of the right, there is divergence in practice in how to account for them, i.e. whether they are leases (and if so, whether finance or operating leases) or whether they are acquisitions of assets on deferred payment terms.

Many intangible assets are capable of being subdivided with the part subject to the lease itself meeting the definition of an intangible asset. If the rights are exclusive, the part will meet the definition of an intangible asset because it is embodied in legal rights that allow the acquirer to control the benefits arising from the asset. For example, an entity might sell to another entity rights to distribute its product in a particular geographical market. If the right is not on an exclusive basis then it may not be within scope of Section 20, e.g. it may be a licensing agreement as discussed at 3.1.1 above. Other arrangements may, on analysis, prove to be for services and not for a right of use of an intangible asset. See 3.1.4 below.

It is irrelevant to the analysis whether the original right is recognised in the financial statements of the lessor prior to the inception of the arrangement.

Rights that do meet the definition of an intangible asset often have a finite life, e.g. a radio station may acquire a licence that gives it a right to broadcast over specified frequencies for a period of seven years. Yet the underlying asset on which the right depends exists both before and after the ‘right’ has been purchased and may have an indefinite life, as is the case with the broadcast spectrum. Many intangible rights can be purchased for an upfront sum, which will be accounted for as the acquisition of an intangible asset that is capitalised at cost. As an alternative to up-front purchase, an entity may pay for the same right in a series of instalments over a period of time. Does it become an operating lease because it is only a short period out of the life of the underlying asset? Usually the answer is no: these rights will not be accounted for as operating leases by comparison to the total life of the underlying asset as the arrangement is over the right in question.

If the arrangement is considered to be a lease, then it will be accounted for in accordance with Section 20, whatever the pattern of payment. If it is a finance lease then the asset will be measured using the methodology prescribed by FRS 102 described at 3.7 below.

If, rather than as a lease, the arrangement is seen as the acquisition of an asset on deferred payment terms, the effective interest rate method is mandated. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period, to the carrying amount of the financial asset or financial liability. The effective interest rate is determined on the basis of the carrying amount of the financial asset or liability at initial recognition. [FRS 102.11.16]. This will take account of estimated future cash payments or receipts through the expected life of the financial instrument that may include some of the ‘contingent’ payments that are excluded from the measurement of finance leases (see 3.4.5 below).

Therefore, there are arguments as to whether there are assets and liabilities to be recognised and, even if recognition is accepted, measurement depends on the view that is taken of the applicable Section. In the absence of a clear principle, there is likely to be diversity in practice.

3.1.3 Leases with non-typical contractual terms classified as financial instruments

Certain leases are not accounted for as leases in accordance with Section 20 but instead classified as financial instruments within scope of Section 12 – Other Financial Instruments Issues – if the lease could, as a result of non-typical contractual terms, result in a loss to the lessor or the lessee. The Basis for Conclusions to FRS 102 states that this could include contractual terms that are unrelated to changes in the price of the leased asset, changes in foreign exchange rates, or a default by one of the counterparties. [FRS 102.BC.B20.1]. The Basis for Conclusions also notes that ‘the reference to “changes in the price of the leased asset” is framed widely and in practice it does not expect many leases to fall within the scope of Section 12.’ Section 12 is addressed in Chapter 10. [FRS 102.BC.B20.2].

Although it is not clear precisely what contractual terms are referred to, it is likely that this does not refer to rents that vary according to:

• non-financial variables specific to the parties to the contract, e.g. rents that vary with future sales or amount of future use; or
• future price indices and future market rates of interest that are relevant to the parties to the contract.

Accounting for these contingent rents is addressed by Section 20 (see 3.4.5 below). Briefly, they are excluded from the minimum lease payments so do not affect the measurement of assets and liabilities in finance leases; instead, whatever the classification of the lease, they are treated as income or an expense as incurred.

3.1.4 Arrangements that include services

Agreements that transfer the right to use assets contain leases even if the lessor is obliged to provide substantial services in connection with the operation or maintenance of the assets. [FRS 102.20.2]. Costs for services are excluded from the minimum lease payments in assessing or measuring leases; see the definition in 3.3 below and the discussion at 3.8.1.B and 3.8.2 below.

A contract for services that does not transfer the right to use assets from one contracting party to the other will not be accounted for under Section 20. [FRS 102.20.2]. Instead, the provider of services will recognise revenue by applying the principles in Section 23 – Revenue – while the purchaser will recognise costs as incurred (see Chapter 20). However, these contracts have to be examined carefully to see if they do, in fact, contain an embedded lease arrangement. See 3.2 below.

Service concession arrangements also contain services as well as the provision of assets. There are separate accounting requirements for these arrangements, which are characterised by control of the asset and services by the ‘grantor’, a public sector body, a public benefit entity or other entity operating to fulfil a public service obligation. The contractual terms of certain contracts or arrangements may meet both the scope requirements of Section 20 and those of Section 34 that pertain to service concessions. Where this is the case, the arrangement must be accounted for as a service concession in accordance with the requirements of Section 34 (see Chapter 31). [FRS 102.34.12C].

3.2.1 A specified asset

Section 20 does not include much additional explanation. It notes that an asset may be explicitly or implicitly identified; in neither case does this automatically mean that the arrangement contains a lease. Although a specific asset may be explicitly identified in an arrangement, it is not the subject of a lease if fulfilment of the arrangement is not dependent on the use of the specified asset. An asset is implicitly specified if, for example, the supplier owns or leases only one asset with which to fulfil the obligation and it is not economically feasible or practicable for the supplier to perform its obligation through the use of alternative assets. [FRS 102.20.3A].

For example, an arrangement in which an entity (the purchaser) outsources its product delivery department to another organisation (the supplier) will not contain a lease if the supplier is obliged to make available a certain number of delivery vehicles of a certain standard specification and the supplier is a delivery organisation with many suitable vehicles available.

The arrangement is more likely to contain a lease if the supplier identifies specific vehicles out of its fleet and those vehicles must be used to provide the service. If the supplier has to supply and maintain a specified number of specialist vehicles in the purchaser's branding, then this arrangement is likely to contain a lease. These arrangements may be commercially more akin to outsourcing the purchaser's acquisitions of delivery vehicles rather than its delivery functions.

Similar issues would have to be taken into account if data processing functions are outsourced as these may require substantial investment by the supplier in computer hardware dedicated to the use of a single customer.

Some arrangements may allow the supplier to replace the specified asset with a similar asset if the original asset is unavailable (e.g. because one of the delivery vehicles has broken down). As this is in effect a warranty obligation it does not preclude lease treatment.

The supplier may have a substantive right to substitute other vehicles at will for the vehicles it has identified. This is common in transport arrangements where a contract may identify the original asset (e.g. a particular truck, aircraft or ship) used for the service but the supplier is not obliged to use the asset identified by the contract. Fulfilment of the arrangement would not then be dependent on the use of the specified asset and the identification of the asset does not indicate that the arrangement contains a lease.

Where arrangements are likely to contain leases (e.g. delivery vehicles in branding, dedicated hardware), the purchaser cannot be unaware that there are specific assets underlying the service. There would have been negotiations between supplier and purchaser that would probably be reflected in the contract documentation. By contrast, if the purchaser does not know what assets are used to provide the service (beyond the fact that they are trucks and computers, of course), and in the circumstances it is reasonable not to know, it is plausible that there is no underlying lease in the arrangement. This remains true even if the supplier has dedicated specific assets to the service being provided and expects their cost to be recouped during the course of the contractual relationship.

3.2.2 A right to use the asset

The arrangement will not contain a lease unless it conveys a right to use the asset. This will be the case where the arrangement conveys to the purchaser the right to control the use of the underlying asset. [FRS 102.20.3A]. Section 20 does not give any further explanation.

IFRS also requires entities to assess whether an arrangement conveys a right to control the use of an identified asset in order to determine whether that arrangement contains a lease, but provides more guidance on making this assessment. [IFRS 16 Appendix B9-31]. Applying the hierarchy in Section 10 – Accounting Policies, Estimates and Errors – entities may choose to look to the requirements of IFRS 16 in developing an accounting policy in this area. Identification of a lease under IFRS 16 is discussed in Chapter 24 of EY International GAAP 2019.

3.4.1 Classification as finance or operating leases

The classification of leases is based on the extent to which the risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return due to changing economic conditions. Rewards may be represented by the expectation of profitable operation over the asset's economic life and of gain from appreciation in value or realisation of a residual value.

Some national standards, including SSAP 21 under previous UK GAAP, include the rebuttable presumption that the transfer of substantially all of the risks and rewards occurs if, at the inception of the lease, the present value of the minimum lease payments amounts to substantially all (normally 90% or more) of the fair value of the leased asset.³ Section 20 provides no numerical guidelines to be applied in classifying a lease as either finance or operating. Lease classification should not be reduced to a single pass or fail test.

Instead, Section 20 takes a more principles-based substance over form approach. It makes the statement that the classification of a lease depends on the substance of the transaction rather than the form of the contract, and lists a number of examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease: [FRS 102.20.5]

1. the lease transfers ownership of the asset to the lessee by the end of the lease term;
2. the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised (frequently called a ‘bargain purchase’ option);
3. the lease term is for the major part of the economic life of the asset even if title is not transferred;
4. 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
5. the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.

All of these are indicators that the lessor will only look to the lessee to obtain a return from the leasing transaction, so it can be presumed that the lessee will, in fact, pay for the asset.

Title does not have to be transferred to the lessee for a lease to be classified as a finance lease. The point is that the lease will almost certainly be classified as a finance lease if title does transfer.

Options such as those referred to under (b) are common in lease agreements. The bargain purchase option is designed to give the lessor its expected lender's return (comprising interest on its investment perhaps together with a relatively small fee), but no more, over the life of the agreement.

Lease term (criterion(c)) must be measured by reference to economic life, which is the period for which the asset is expected to be usable by one or more users, not the physical life. The economic life will usually be shorter than the physical life if the asset is subject to technological obsolescence. A computer may be capable of use for six or seven years but would rarely be used beyond three years. It is not so well appreciated that buildings suffer from technological obsolescence which means that an office building with a fabric life of sixty years may have an economic life of half of that. It becomes increasingly hard to adapt buildings to rapidly-changing IT or energy efficiency requirements. The residual value of these assets at the end of the economic life is minimal.

The economic life would therefore include additional lease terms with the same or different lessees. It is not the same as the useful life which is specific to the lessee and is the estimated remaining period, from the commencement of the lease term but without the limitation of the lease term, over which the entity expects to consume the economic benefits embodied in the asset (see 3.7.1.D below).

Criteria (c) and (d) above also include the unquantified expressions ‘major part of’ and ‘substantially all’, which means that judgement must be used in determining their effect on the risks and rewards of ownership. By contrast, in US GAAP the equivalent to (c) above in Accounting Standards Codification [ASC] 840 – Leases⁴ – does quantify when a lease will be a capital lease (the equivalent of a finance lease). In ASC 840, if the lease term is equal to 75% or more of the estimated economic life of the leased asset, the lease will normally be a capital lease (there is an exception if the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased asset, including earlier years of use, where this criterion is not used for purposes of classifying the lease).⁵ In practice, if the lease is for the major part of the economic life of the asset, it is unlikely that the lessor will rely on any party other than the lessee to obtain its return from the lease. This would still not be conclusive evidence that the lease should be classified as a finance lease. There could be other terms that indicate that the significant risks and rewards of ownership rest with the lessor, e.g. lease payments might be reset periodically to market rates or there might be significant technological, obsolescence or damage risks borne by the lessor.

Similarly, whilst (d) above refers to the present value of the minimum lease payments being at least ‘substantially all of the fair value of the asset’, it does so without putting a percentage to it; FRS 102, unlike previous UK GAAP, has no ‘90% test’. However, we see no harm in practice in at least applying the ‘90% test’ as a rule of thumb benchmark as part of the overall process in reaching a judgement as to the classification of a lease. Clearly, though, it cannot be applied as a hard and fast rule.

For an example of the 90% test, see Example 18.4 at 3.5 below. In that example, the present value of the minimum lease payments is calculated to be 92.74% of the asset's fair value; as this exceeds 90%, this would normally indicate that the lease is a finance lease. Nevertheless, the other criteria discussed above would need to be considered as well.

Consequently, we would stress that the 90% test is not an explicit requirement and should not be applied as a rule or in isolation, but it may be a useful tool to use in practice in attempting to determine the economic substance of a lease arrangement.

Section 20 provides the following indicators of situations that, individually or in combination, could also lead to a lease being classified as a finance lease: [FRS 102.20.6]

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

Section 10 notes that these examples are only indicators and are not always conclusive. If it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership, the lease is classified as an operating lease. For example, this may be the case if ownership of the asset is transferred to the lessee at the end of the lease for a variable payment equal to the asset's then fair value, or if there are contingent rents, as a result of which the lessee does not have substantially all risks and rewards incidental to ownership. [FRS 102.20.7].

Other considerations that could be made in determining the economic substance of the lease arrangement include the following:

• Are the lease rentals based on a market rate for use of the asset (which would indicate an operating lease) or a financing rate for use of the funds, which would be indicative of a finance lease? and
• Is the existence of put and call options a feature of the lease? If so, are they exercisable at a predetermined price or formula (indicating a finance lease) or are they exercisable at the market price at the time the option is exercised (indicating an operating lease)?

These two considerations mean that an arrangement for the whole of an asset's useful life may be an operating lease, as may an agreement in which the lessee has a right to obtain title to the asset at market value.

3.4.2 Inception and commencement of the lease

It is important to distinguish between the inception of the lease (when leases are classified) and the commencement of the lease term (when recognition takes place).

The inception of the lease is the earlier of the date of the lease agreement and the date of commitment of the parties to the principal terms of the lease. [FRS 102 Appendix I]. This is the date on which a lease is classified as a finance or operating lease.

The commencement of the lease term is the date on which the lessee is entitled to exercise its right to use the leased asset and is the date of initial recognition of the assets, liabilities, income and expenses of the lease in the financial statements. [FRS 102 Appendix I].

This means that the entity makes an initial calculation of the assets and liabilities under a finance lease at inception of the lease but does not recognise these in the financial statements until the commencement date, if this is later. The amounts in the initial calculation may in some circumstances be revised. It is not uncommon for the two dates to be different, especially if the asset is under construction. Section 20 requires the lessee under a finance lease to recognise the asset at its fair value or, if lower, at the present value of the minimum lease payments, determined at the inception of the lease. [FRS 102.20.9]. This means that, if the final cost of the asset, and hence its fair value, is not known until after the date of inception, hindsight should be used to establish that fair value.

Sometimes lease payments may be adjusted for changes in the lessor's costs during the period between inception and commencement. The lease may allow for changes in respect of costs of construction, acquisition costs, changes in the lessor's financing costs and any other factor, such as changes in general price levels, during the construction period. Such changes are also relevant in establishing the fair value and minimum lease payments for the purposes of Section 20. In our view, changes to the lease payments as a result of such events should be deemed to take place at inception of the lease and be taken into account in establishing whether it is a finance or operating lease at inception and, if it is a finance lease, the amount at which the asset and liability should be recorded (see 3.7 below). A contract might estimate the cost of construction to be £1 million but allow for additional specific increased costs of up to 5% to be reflected in increased payments made by the lessee. If those increased costs are incurred, then the fair value and minimum lease payments at inception will take account of the increased cost of the asset (£1.05 million) and the increased lease payments.

The fair value may be known at inception but payment delayed until commencement, which may happen with large but routinely constructed assets such as aircraft or railway locomotives. The lease liability will increase between the date of inception and the date of commencement, taking account of payments made and the interest rate implicit in the lease. Again, this is not addressed by Section 20 but, in our view, the lessee ought to add the increase in the liability until the commencement date to the asset. It is not a finance cost on the liability (no liability is recognised prior to commencement) and nor need it be an expense. It is not appropriate to recognise at commencement the liability that was calculated at inception as that would change the interest rate implicit in the lease.

Circumstances in which lease classification might be changed are discussed at 3.4.3 below.

3.4.3 Changes to the classification of leases

Classification is not changed during the term of the lease unless the lessee and the lessor agree to change the provisions of the lease (other than simply by renewing the lease), in which case the lease classification must be re-evaluated. [FRS 102.20.8].

Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased item) or changes in circumstances (for example, default by the lessee) do not result in the lease being reclassified for accounting purposes.

The distinction between changes to the provisions of the lease and changes in estimate is that the former, unlike the latter, are always the result of agreements between the lessee and lessor.

Section 20 does not address the measurement of these changes. References to the relevant parts of this chapter in which the changes are dealt with are given below.

(a) Changes to the provisions or terms of an existing lease (‘modifications’)

Changes to the provisions or terms of an existing lease (referred to here as ‘modifications’) are changes to the contractual terms and conditions that are not part of the original lease. Modifications that affect a lease's classification are those that affect the risks and rewards incidental to ownership of the asset by changing the terms and cash flows of the existing lease. Examples of modifications that could affect classification include those that change the duration of the lease and the number, amount and timing of lease payments or the inclusion or an option to acquire not previously part of the lease terms.

The revised agreement resulting from the modification is considered as if it were a new agreement which should be accounted for appropriately, as a finance or operating lease, prospectively over the remaining term of the lease.

FRS 102 does not give any specific guidance on how to assess whether modified lease terms give rise to a new classification so the general classification rules described in 3.4.1 above must be applied. Nor does it explain how to measure modifications of leases if changes affect the value of the assets and liabilities for both lessor and lessee. These issues are discussed at 3.9 below. See 3.9.1 below for discussion on how to assess whether the classification has changed, based on the revised cash flows, and see 3.9.2 below for how to account for the reclassification.

If lease terms are modified but the classification does not change, the entity will still have to account for the modified cash flows. How to account for the changes if a finance lease remains a finance lease is discussed at 3.9.3.A below. Accounting for changes to the terms of operating leases, where those changes do not result in reclassification, is considered at 3.9.3.B below.

Some changes to lease terms will not affect the cash flows at all, e.g. those that change terms such as the names of the contracting parties. Other changes could affect only the lessor, e.g. a transfer from one lessor to another that requires no consent or other action by the lessee and where there is no change to the lease cash flows.

(b) the lessor and lessee renew the lease

If the lessee and lessor renew the lease, this could mean one of the following:

• Exercising an option to extend the lease or purchase the underlying asset, when these options were included in the original lease but exercise of the options was not considered probable at its inception. Changes in circumstances or intentions do not give rise to a new classification of the original lease, unless they indicate that the initial classification was made in error because it was not based on the substance of the arrangement at the time it was entered into. This means that the intention to exercise a renewal option in a lease originally classified as an operating lease will not change that classification.
• Entering into a new lease with the lessor. For example, an entity may have a right to ‘renew’ a lease of business premises for a further term after expiry of the initial term at the market rent at the date the new agreement is entered into. This is not a change to the terms of the original lease. It may be under the terms of a statutory right to extend commercial leases found in many jurisdictions, whose purpose is to ensure that businesses are not forced to relocate. This is similar in effect to an option to extend at market value so under a risks and rewards model the secondary term would not pass the significant risks and rewards to the lessee.

  The lessor and lessee could revoke the original lease and enter into a new one in its place, which would also be considered a renewal. It is necessary to ensure that the new lease terms are at fair value at the time it is entered into so it does not reflect, for example, underpayments made by the lessee under the terms of the original lease.

• Extending the existing lease without changing any other term, e.g. with the consent of the lessor, continuing to use the asset for a period of time after the original expiry at the original rental. This has to be distinguished on the facts from a negotiation between the lessee and lessor that changes the terms of the original lease before its expiry, although this will probably also include other changes such as a different rental.

A new, renewed or extended lease will be classified on its own terms without any consideration of the terms and provisions of the original lease.

3.4.4 Lease term

The lease term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. [FRS 102 Appendix I].

A lease may contain terms that effectively force the lessee to continue to use the asset for the period of the agreement. Arguably, the substance of the transaction should be taken into account. Therefore, a lease may be non-cancellable if it can be cancelled only:

1. on the occurrence of a remote contingency;
2. with the permission of the lessor;
3. if the lessee enters into a new lease with the same lessor for the same or an equivalent asset; or
4. if the lessee is required to pay additional amounts that make it reasonably certain at inception that the lessee will continue the lease.

An example of (d) is a requirement that the lessee pays a termination payment equivalent to the present value of the remaining lease payments.

3.4.5 Contingent rent and minimum lease payments

Contingent rent is that portion of the lease payments that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time (e.g. percentage of future sales, amount of future use, future price indices, and future market rates of interest). [FRS 102 Appendix I].

In the case of finance leases, contingent rents are excluded from minimum lease payments. Lessees charge contingent rents as expenses in the periods in which they are incurred. [FRS 102.20.11].

Contingent payments will be taken into account in assessing whether substantially all of the risks and rewards of ownership have been transferred; for example, property rentals that are periodically reset to market rates would tend to indicate that risks and rewards rest with the lessor – see the discussion at 3.4.1 above. This still leaves open to debate whether a particular ‘contingency’ is in fact contingent or is so certain that it ought to be reflected in the minimum lease payments for the purposes of classifying the lease. In practice this will always be based on an assessment of the individual circumstances.

For operating leases, FRS 102 is not explicit on the treatment of contingent rent. Current practice is to exclude an estimate of such amounts from the total operating lease payments or lease income to be recognised on a straight-line basis over the lease term. Accordingly, contingent lease payments or receipts under operating leases are generally recognised in the period in which they are incurred. Views are divided on whether minimum lease payments determined at the inception of the lease are revised on the occurrence of the contingency, e.g. whether minimum lease payments change when there are rent revisions that are stipulated in the original lease agreement, either for straight-line recognition or disclosure purposes. In the case of contingencies based on an index, such as a retail price index, it is our view that disclosure should reflect all contingencies that have occurred in future minimum lease disclosures. This is on the basis that the contingency has occurred and Section 20 specifies disclosure of future minimum lease payments. [FRS 102.20.16, 30]. If the initial payment before any indexation changes was 100 per year and at the end of year 1, the index was 102.5, the minimum lease payments for disclosure purposes at the end of year 1 would be 102.5 for each remaining year of the lease term.

Section 20 excludes from its scope ‘leases that could lead to a loss to the lessor or the lessee as a result of non-typical contractual terms’. [FRS 102.20.1(e)]. These contractual terms would be unrelated to changes in the price of the leased asset, changes in foreign exchange rates, or a default by one of the counterparties. [FRS 102.BC.B20.1]. Generally we would expect this to exclude contingent rents relating to the factors described above as they are not included in the measurement of assets and liabilities. Leases excluded from scope on this basis are discussed at 3.1.3 above and 3.6 below.

3.4.6 Residual values

The guaranteed residual value is:

1. for a lessee, the part of the residual value that is guaranteed by itself or by one of its related parties. The amount of the guarantee is the maximum amount that could, in any event, become payable; and
2. for a lessor, the part of the residual value that is guaranteed by the lessee, a party related to the lessee, or by a third party unrelated to the lessor who is financially capable of discharging the obligations under the guarantee. [FRS 102 Appendix I].

This means that the lessor's unguaranteed residual value is any part of the residual value of the leased asset, whose realisation is not assured or is guaranteed solely by a related party of the lessor. If the net present value of the residual value of an asset is significant and is not guaranteed by the lessee or a party related to it, then the lease is likely to be classified as an operating lease by the lessee. The lessee will not bear the risks of recovering the significant residual value; consequently it is unlikely that ‘substantially all’ of the risks and rewards of ownership will have passed to the lessee. However, as can be seen from Example 18.1 at 3.4.1.A above, the provision of a residual value guarantee by a lessee does not necessarily mean that the lease will not be classified as an operating lease by the lessee.

There are frequently problems of interpretation regarding the significance of residual values in lease classification. Lessees may find it difficult to obtain information in order to calculate the unguaranteed residual values.

If lessees guarantee all or part of the residual value of the asset, this has to be taken into account in the lease classification.

If a related party, e.g. a member of the same group as the lessee, guarantees the residual, this can result in recognition of a finance lease in the consolidated financial statements and an operating lease in the individual entity. This assumes that there are no intra-group arrangements that transfer the guarantee back to the lessee.

3.5.1 Fair value

Fair value is defined as the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length transaction. [FRS 102 Appendix I]. Additional guidance is given in the appendix to Section 2 (see Chapter 4). Although the additional guidance does not refer to Section 20, it is used as guidance in establishing the fair value of property, plant and equipment and will therefore be relevant in establishing the fair value of assets held under leases. [FRS 102.17.15C].

In practice, the transaction price, i.e. the purchase price of the asset that is the subject of the lease, will be its fair value, unless there is evidence to the contrary.

3.7.1 Accounting by lessees

3.7.2 Accounting by lessors

Under a finance lease, a lessor retains legal title to an asset but passes substantially all the risks and rewards of ownership to the lessee in return for a stream of rentals. In substance, therefore, the lessor provides finance and expects a return thereon.

Lessors are required to recognise assets held under a finance lease in their statement of financial position as a receivable at an amount equal to the net investment in the lease. The net investment in a lease is the lessor's gross investment discounted at the interest rate implicit in the lease. The gross investment in the lease is the aggregate of:

1. the minimum lease payments receivable by the lessor under a finance lease; and
2. any unguaranteed residual value accruing to the lessor. [FRS 102.20.17].

Initial direct costs (costs that are incremental and directly attributable to negotiating and arranging a lease) may include commissions, legal fees and internal costs. They are included in the measurement of the net investment in the lease at inception, except in the case of finance leases involving manufacturer or dealer lessors. [FRS 102.20.18].

As they are included in the initial measurement of the finance lease receivable, they reduce the amount of income recognised over the lease term.

At any point in time the net investment comprises the gross investment after deducting gross earnings allocated to future periods. The lessor's gross investment is, therefore, the same as the aggregate figures used to calculate the implicit interest rate and the net investment is the present value of those same figures – see Example 18.4 above. Therefore, at inception, the lessor's net investment in the lease is the cost of the asset as increased by its initial direct costs. The difference between the net and gross investments is the gross finance income to be allocated over the lease term. Example 18.8 below illustrates this point.

3.7.3 Residual values

Residual values have to be taken into account in assessing whether a lease is a finance or operating lease as well as affecting the calculation of the IIR and finance income.

• Unguaranteed residual values have to be estimated in order to calculate the IIR and finance income receivable under a finance lease. If there is an indication that the estimated unguaranteed residual value has changed significantly, the income allocation over the lease term is revised, and any reduction in respect of amounts accrued is recognised immediately in profit or loss. Any impairment in the residual must be taken into account. [FRS 102.20.19]. This is illustrated at 3.7.3.A below.
• Residual values can be guaranteed by the lessee or by a third party. The effects of third party guarantees on risks and rewards are described at 3.4.6.A above.
• The terms of a lease guarantee can affect the assessment of the risks and rewards in the arrangement as in Example 18.1 at 3.4.1.A above.
• A common form of lease requires the asset to be sold at the end of the lease term. The disposition of the proceeds has to be taken into account in assessing who bears residual risk, as described at 3.4.1.B above.

3.7.4 Termination of finance leases

The expectations of lessors and lessees regarding the timing of termination of a lease may affect the classification of a lease as either operating or finance. This is because it will affect the expected lease term, level of payments under the lease and expected residual value of the lease assets.

Termination during the primary lease term will generally not be anticipated at the lease inception because the lessee can be assumed to be using the asset for at least that period. In addition, early termination is made less likely because most leases are non-cancellable. A termination payment is usually required which will give the lessor an amount equivalent to most or all of the rental receipts which would have been received if no termination had taken place, which means that it is reasonably certain at inception that the lease will continue to expiry.

However, there are consequences if the lease is terminated. The issues for finance lessees and lessors are discussed in the following sections.

3.7.5 Manufacturer or dealer lessors

Manufacturers or dealers often offer customers the choice of either buying or leasing an asset. While there is no selling profit on entering into an operating lease because it is not the equivalent of a sale, a finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income:

1. the profit or loss equivalent to the profit or loss resulting from an outright sale of the asset being leased, at normal selling prices, reflecting any applicable volume or trade discounts; and
2. the finance income over the lease term. [FRS 102.20.20].

If the customer is offered the choice of paying the cash price for the asset immediately or paying for it on deferred credit terms then, as long as the credit terms are the manufacturer or dealer's normal terms, the cash price (after taking account of applicable volume or trade discounts) can be used to determine the selling profit. However, in many cases such an approach should not be followed as the manufacturer or dealer's marketing considerations often influence the terms of the lease. For example, a car dealer may offer 0% finance deals instead of reducing the normal selling price of his cars. It would be wrong in this instance for the dealer to record a profit on the sale of the car and no finance income under the lease.

Sales revenue is therefore to be based on the fair value of the asset (i.e. usually the cash price) or, if lower, the present value of the minimum lease payments computed at a market rate of interest. As a result, selling profit is restricted to that which would apply if a commercial rate of interest were charged. The cost of sale is reduced to the extent that the lessor retains an unguaranteed residual interest in the asset. Selling profit is recognised in accordance with the entity's policy for outright sales. [FRS 102.20.21]. This also means that the entity will ignore artificially low rates of interest quoted by the lessor; profit will be restricted by substituting a market rate of interest. [FRS 102.20.22].

Initial direct costs should be recognised as an expense in the income statement at the inception of the lease when the selling profit is recognised. [FRS 102.20.22]. This is not the same as the treatment when a lessor arranges a finance lease where the costs are added to the finance lease receivable; this is because the costs are related mainly to earning the selling profit.

If the manufacturer or dealer is in the relatively unlikely position of incurring an overall loss because the total rentals receivable under the finance lease are less than the cost to it of the asset then this loss should be taken to the income statement at the inception of the lease. This emphasises the importance of calculating an appropriate market interest rate.

If the manufacturer or dealer does not conduct other leasing business, an estimate will have to be made of the implicit rate for the leasing activity.

3.8.1 Operating leases in the financial statements of lessees

Lease payments under an operating lease, excluding costs for services such as insurance and maintenance, are to be recognised as an expense on a straight-line basis over the lease term unless:

1. another systematic basis is representative of the time pattern of the user's benefit, even if the payments are not on that basis; or
2. the payments to the lessor are structured to increase in line with expected general inflation (based on published indexes or statistics) to compensate for the lessor's expected inflationary cost increases. [FRS 102.20.15].

Payments that vary because of factors other than general inflation will not meet condition (b). [FRS 102.20.15(b)].

Generally, the only bases that are considered acceptable under (a) apart from the straight-line basis are those where rentals are based on a unit of use or unit of production.

Section 20 requires straight-line recognition of the lease expenses that do not fall within (b) even when amounts are not payable on this basis. This does not require the entity to anticipate contingent rental increases, such as those that will result from a periodic re-pricing to market rates or those that are based on some other index. Although FRS 102 is not explicit on this point, we expect that entities will expense these contingent rents as incurred.

However, lease payments may vary over time for other reasons that will have to be taken into account in calculating the annual charge. Described in more detail below are some examples: leases that are inclusive of services and leases with increments intended to substitute for inflation.

Lease incentives are another feature that may affect the cash flows under a lease; they are dealt with in more detail at 3.8.1.C (for lessees) and 3.8.2.A (for lessors).

3.8.2 Operating leases in the financial statements of lessors

Lessors should present assets subject to operating leases in their statements of financial position according to the nature of the asset, i.e. usually as PP&E or as an intangible asset. [FRS 102.20.24].

Lease income from operating leases should be recognised in income on a straight-line basis over the lease term, unless another systematic basis is representative of the time pattern of the lessee's benefit from the leased asset. [FRS 102.20.25]. Generally, the only other basis that is encountered is based on unit-of-production or service.

In the same way as for lessees, payments to the lessor that are structured to increase in line with expected general inflation (based on published indexes or statistics) to compensate for the lessor's expected inflationary cost increases are exempt from the requirement to be accounted for on a straight-line basis. This is the mirror image of accounting by lessees, so the guidance described in detail at 3.8.1.A above is also relevant for lessors. [FRS 102.20.25].

Lease income excludes receipts for services provided such as insurance and maintenance. Section 23 provides guidance on how to recognise service revenue (see Chapter 20). Costs, including depreciation, incurred in earning the lease income are recognised as an expense. [FRS 102.20.26]. Initial direct costs incurred specifically to earn revenues from an operating lease are added to the carrying amount of the leased asset and allocated to profit or loss as an expense over the lease term on the same basis as the lease income. [FRS 102.20.27]. This means that the costs will be depreciated on a straight-line basis if this is the method of recognising the lease income, regardless of the depreciation basis of the asset.

As there are no specific requirements about depreciation in Section 20, the entity will depreciate leased assets in a manner that is consistent with the entity's policy for similar assets under Section 17 (see Chapter 15). This also means that the lessor is obliged to consider the residual value, useful life and depreciation method of the assets if there is any indication that these have changed since the last financial statements were prepared. [FRS 102.17.19, 23]. There are similar requirements in the case of intangible assets in Section 18 (see Chapter 16) although they rarely have a residual value because of the conditions that must apply before recognition. [FRS 102.18.23-24]. These assets are also tested for impairment in a manner consistent with other tangible and intangible fixed assets applying the requirements of Section 27 – Impairment of Assets (see Chapter 24). [FRS 102.20.28].

Manufacturer or dealer lessors do not recognise any selling profits on entering into operating leases because they are not the equivalent of a sale. [FRS 102.20.29].

3.8.3 Payments made in connection with the termination of operating leases

Payments for terminating operating leases are extremely common. FRS 102 states that any such costs incurred by the lessee, such as costs for termination of a pre-existing lease, relocation or leasehold improvements are to be accounted for in accordance with the applicable section of the FRS. [FRS 102.20.15A]. Example 18.14 below addresses a situation for a variety of payments that might arise in connection with terminating an operating lease over a property and suggests ways in which they might be accounted for.

3.9.1 Determining whether there is a different classification

This section addresses ways of assessing whether the lease classification has changed. Accounting for reclassified leases is addressed at 3.9.2 below while changes that do not result in reclassification but that must nevertheless be addressed are considered at 3.9.3 below.

While the focus of the section is on ways of quantifying differences between the original and modified lease, all features of any arrangement must be considered as part of an assessment of whether or not the modified lease transfers substantially all of the risks and rewards of ownership. However, in order for a change to the provisions of a lease to result in a change of classification, it must be one that affects the risks and rewards incidental to ownership of the asset by changing the terms and cash flows of the existing lease. An example of such a change is a renegotiation that changes the lease's duration and/or the payments due under the lease.

One of the indicators used in practice is an assessment of the net present value of the minimum lease payments and whether or not these amount to substantially all of the fair value of the leased asset. An entity might use this test to help assess whether the revised lease is a finance or operating lease, in conjunction with a reassessment of the other factors described at 3.4.1 above. Therefore, the entity might use one of the following methods to calculate the net present value:

1. recalculate, as per the original date of inception of the lease, the net present value of the minimum lease payments based on the revised lease term and cash flows (and revised residual value, if relevant), which will result in a different implicit interest rate to that used in the original calculation;
2. take into consideration the changes in the agreement but calculate the present value of the asset and liability using the interest rate implicit in the original lease. This approach is consistent with the remeasurement of the carrying value of financial instruments applying the effective interest rate method. This will result in a ‘catch up’ adjustment as at the date of the reassessment; or
3. consider the revised agreement to be a new lease and assess the classification based on the terms of the new agreement and the fair value and useful life of the asset at the date of the revision. The inference of this method, unlike (a) and (b), is that the entity already considers that there is likely to be a new classification to the lease, based on an assessment of other factors.

The methodology is straightforward in the case of (a) and (c) above as it involves using updated cash flows, either from inception (method (a)) or from the date of the revised agreement (method(c)) to calculate the net present value, using the methodology described at 3.5 above and illustrated in Example 18.15 below. A lessee under a lease originally classified as an operating lease will be able to apply both of these methods but method (b) will not be available to it unless it has sufficient information to be able to calculate the IIR at the inception of the original lease. Lessees that are party to more complex leases or sale and leaseback arrangements are more likely to have the necessary information available to them.

Each of these three approaches is likely to lead to a different net present value for the minimum lease payments.

3.9.2 Accounting for reclassified leases

If the original lease was a finance lease and the revised lease is an operating lease, then the balances relating to the finance lease must be derecognised. For the lessee, this involves derecognising both the asset (which will have been depreciated up to the point of derecognition over the shorter of the useful life or the lease term) and the finance lease liability. Finance lease derecognition is discussed further at 3.7.4 above.

If the original lease was an operating lease and the revised lease is a finance lease, then any balances resulting from recognising the lease cost on a straight-line basis will be expensed and the balances relating to the finance lease must be recognised for the first time.

The most obvious way in which to account for the revised finance lease is as a new lease as from the date on which the terms were changed, either based on an implicit interest rate modified to reflect the revised lease term and revised cash flows (method (a) in 3.9.1 above) or the revised lease term, cash flows, and fair value of the assets as at the date of revision (method (c) in 3.9.1 above). In the facts as in Example 18.15 above, the assets and liabilities under the finance lease would be recognised initially as:

• £16,655, being the present value of the revised remaining lease payments applying method (a) from 3.9.1 above; or
• £16,126, being the present value of the revised remaining lease payments applying method (c) from 3.9.1 above.

However, it is also acceptable to recognise the new lease using method (b) above, by taking into consideration the changes in the agreement but calculating the present value of the asset and liability by using the interest rate implicit in the original lease. This uses an accepted methodology and is consistent with the fact that there has, in fact, only been a change to the original terms and not a completely new lease; it also has the advantage that the revised fair value of the asset does not have to be known. In the facts as in Example 18.15 above, this means that the asset and liability would be recorded at £16,178.

If the original lease agreement and the revised lease agreement are both finance leases, then the modification will have accounting consequences that are discussed in the following section.

3.9.3 Changes to leases terms that do not result in reclassification

3.10.1 Sale and finance leaseback

In order to assess whether the leaseback is under a finance lease, the seller/lessee will apply the qualitative tests that are described at 3.4.1 above. If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds over the carrying amount should not be recognised immediately as income by a seller/lessee. Instead, the excess is deferred and amortised over the lease term. [FRS 102.20.33].

It is inappropriate to show a profit on disposal of an asset which has then, in substance, been reacquired by the entity under a finance lease as the lessor is providing finance to the lessee with the asset as security.

The implication of Section 20 is that the previous carrying value is left unchanged, with the sales proceeds being shown as a liability, usually accounted for under Section 11 (see Chapter 10). The creditor balance represents the finance lease liability under the leaseback. This treatment is consistent with Section 23 (see Chapter 20) as the seller/lessee has by definition not transferred to the buyer the significant risks and rewards of ownership of the goods. [FRS 102.23.10(a)]. Therefore it would not be recorded as a sale.

However, another way of accounting for the transaction is for the asset to be restated to its fair value (or the present value of the minimum lease payments, if lower) in exactly the same way as any other asset acquired under a finance lease.

Both treatments have the same net effect on the income statement.

If the sales value is less than the carrying amount, the apparent ‘loss’ does not need to be taken to profit or loss unless there has been an impairment under Section 27. There may be an obvious reason why the sales proceeds are less than the carrying value; for example, the fair value of a second-hand vehicle or item of plant and machinery is frequently lower than its carrying amount, especially soon after the asset has been acquired by the entity. This fall in fair value after sale has no effect on the asset's value-in-use. What this means is that in the absence of impairment, a deficit (sales proceeds lower than carrying value) may be deferred in the same manner as a profit and spread over the lease term.

3.10.2 Sale and operating leaseback

If a sale and leaseback transaction results in an operating lease, and it is clear that the transaction is established at fair value, any profit or loss should be recognised immediately by the seller/lessee. If the sale price is below fair value, any profit or loss should be recognised immediately unless the loss is compensated for by future lease payments at below market price, in which case it should be deferred and amortised in proportion to the lease payments over the period for which the asset is expected to be used. If the sale price is above fair value, the excess over fair value should be deferred and amortised over the period for which the asset is expected to be used. [FRS 102.20.34].

The rationale behind these treatments is that if the sales value is not based on fair values then it is likely that the normal market rents will have been adjusted to compensate. For example, a sale at above fair value followed by above-market rentals is similar to a loan of the excess proceeds by the lessor that is being repaid out of the rentals. Accordingly, the transaction should be recorded as if it had been based on fair value.

Where the sales value is less than fair value there may be legitimate reasons for this to be so, for example where the seller has had to raise cash quickly. In such situations, as the rentals under the lease have not been reduced to compensate, the profit or loss should be based on the sales value.

The following table is intended to assist in interpreting the various permutations of facts and circumstances.

3.10.3 Sale and leaseback arrangements with put and call options

Sale and leaseback arrangements may also include features such as repurchase options. These are not directly addressed by FRS 102 but affect the disposition of risks and rewards in the overall arrangement.

If a lease arrangement includes an option that can only be exercised by the seller/lessee at the then fair value of the asset in question, the risks and rewards inherent in the residual value of the asset have passed to the buyer/lessor. The option amounts to a right of first refusal to the seller/lessee.

Where there is both a put and a call option in force on equivalent terms at a determinable amount other than the fair value, it is clear that the asset will revert to the seller/lessee. It must be in the interests of one or other of the parties to exercise the option so as to secure a profit or avoid a loss, and therefore the likelihood of the asset remaining the property of the buyer/lessor rather than reverting to the seller must be remote. In such a case, this is a bargain purchase option and the seller/lessee has entered into a finance leaseback.

However, the position is less clear where there is only a put option or only a call option in force, rather than a combination of the two. The overall commercial effect will have to be evaluated and one-sided options may be an indication that the arrangement contains non-typical contractual terms which will put it out of scope of lease accounting altogether (see 3.1.3 above).

These arrangements are not common in practice and further discussion is beyond the scope of this publication.

3.11.1 Disclosures by lessees

In addition to the specific disclosure requirements for finance and operating leases set out below, Section 3 – Financial Statement Presentation – contains the requirement to disclose accounting policies (see Chapter 6).

3.11.2 Disclosures by lessors

3.11.3 Disclosures of sale and leaseback transactions

Disclosure requirements for lessees and lessors apply equally to sale and leaseback transactions. The required description of significant leasing arrangements includes description of unique or unusual provisions of the agreement or terms of the sale and leaseback transactions. [FRS 102.20.35].