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Home > Regulation Best Practice > Classification and Treatment of Leases

Regulation Best Practice

Classification and Treatment of Leases

by Roger Lister

Executive Summary

  • Accounting bodies, both international and national, require leases to be classified in terms of economic substance rather than legal form.

  • Current regulation distinguishes a finance lease from an operating lease. If a lease transfers the risks and rewards of an asset to the lessee, it is a finance lease. Otherwise, the lease is an operating lease. A finance lease appears in the balance sheet; an operating lease may remain off the balance sheet.

  • New international and national accounting standards will almost certainly remove the distinction. Except for very short leases, all will go on the balance sheet.

  • The change will eliminate a sometimes artificial distinction, but higher reported leverage may have ill effects. Management may avoid otherwise desirable leasing to protect the leverage ratio. Bond covenants may be breached and need to be renegotiated. There may be an incentive to circumvent the standard by taking out a succession of short but renewable leases.

  • Tax allowances emphasize legal form, but tax in its detail tends to follow accounting standards. Companies will therefore need to consider the tax impact of the new standard as it solidifies.

  • Anti-avoidance tax legislation proliferates daily and will probably increase as governments seek every opportunity to raise revenue in straitened times. At worst, a measure will be retrospective. Planners should monitor discussion and attempt the difficult task of identifying and anticipating the most likely changes, including anti-avoidance legislation.

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Introduction

Lease accounting is nearer than ever to its goal of reporting substance rather than form. International regulators and their national counterparts agree that right-to-use rather than legal title should determine the classification and treatment of leases. The choice is essentially between disclosing a lease as a financial instrument on the balance sheet or as an operating lease on the income statement.

Financial reporting of leases is addressed in the International Accounting Standards Board’s International Accounting Standard IAS 17. The International Accounting Standards Board (IASB) benefits from the participation of many countries, including the US Financial Accounting Standards Board (FASB).

Why lease? Management needs to test conventional answers carefully since some have limited relevance, while others are frankly contestable. Leasing is sometimes promoted for its small initial outlay, even as 100% financing. This ignores the fact that a rational lessor like a lender will seek a cushion of equity to protect the finance provided. A more rational answer is that leasing is advantageous if it provides more finance than the borrowing which it displaces. Management is essentially asking how far, for their company, is leasing a substitute for borrowing and how far a complement. Research suggests that leasing tends to be a substitute for borrowing for larger firms and a valuable complement to borrowing for small and medium enterprises (SMEs). Leasing can help to overcome SMEs’ difficulty in conveying their quality to would-be financiers.

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Classification

Currently, the essential distinction is between the finance and the operating lease, but it is virtually certain that under the revised international financial reporting standard due about 2011 this distinction will disappear. The new classification will equate finance and operating leases. All but the shortest contracts will be treated like finance leases. New national standards will probably anticipate, accompany, or follow the new international standard.

A finance lease transfers substantially all the risks and rewards of asset ownership to the lessee and features accordingly in the balance sheet. An operating lease remains off balance sheet. If a lease satisfies any one or more of certain criteria, then it may be a finance lease. These are:

  • Ownership of the asset is transferred to the lessee at the end of the lease term;

  • The lease contains a bargain purchase option to buy the equipment at less than fair market value;

  • The lease term is for the major part of the economic life of the asset even if title is not transferred;

  • At the inception of the lease, the present value of the minimum lease payments amounts at least substantially to all of the fair value of the leased asset;

  • The leased assets are of a specialized nature such that only the lessee can use them without major modification;

  • Any cancellation losses are borne by the lessee;

  • The lessee takes gains and losses on the asset’s residual value;

  • The lessee can rent for a secondary period for less than the market rent.

The international standard, unlike some national standards, does not focus on a numerical percentage of fair asset value (typically 90%).

“Asset” means the lower of the fair value and the present value of the minimum lease payments (MLP). MLP are discounted at the interest rate implicit in the lease if practicable, or else at the enterprise’s incremental borrowing rate. Depreciation has to be consistent with that for similar owned assets. If ultimate ownership is unlikely, the asset has to be depreciated over the shorter of the lease term and the life of the asset. The income statement includes depreciation and the finance charge. Rental payments are recognized as part finance charge and part repayment of the liability to the lessor. Repayments of the obligation reduce the liability in the balance sheet.

In the case of operating leases, periodic rentals are charged in total against income on a straight-line basis, unless another systematic basis is more representative of the time pattern of the user’s benefit. Any outstanding rentals are reported in the balance sheet, distinguishing maturities and categories of activity.

IAS 17 is further explained in SIC 15, SIC 27 and IFRIC 4 and 12. SIC 15 states that any incentives such as rent-free periods or contributions by the lessor to the lessee’s relocation costs should be reported as a reduction of lease income or lease expense. IFRIC (a standard issued post 2001) 4 and 12 consider cases where a right to use, while not a lease in form, may amount to a lease for financial reporting purposes. Examples are outsourcing arrangements, telecommunication contracts that provide rights to capacity, and take-or-pay and similar contracts in which purchasers must make specified payments regardless of whether they take delivery of the contracted products or services.

Current classification and treatment of leasing has already brought financial reporting closer to economic reality, and the new standard will continue this progress. It will break down deceptive barriers between economically similar transactions. However, management needs to recognize potentially perverse effects. Reported leverage will increase if finance and operating leases are both on the balance sheet, possibly causing management to avoid otherwise beneficial leases. Bond covenants may be nominally breached and have to be renegotiated. Without suitable safeguards, companies may circumvent the standard by taking out short but renewable leases that will in practice span an asset’s useful life.

In the case of leveraged leasing (not under discussion here), the lessee gains access to the lessor’s leveraged capital. The lessor owns the asset but typically provides only some 25% of capital while garnering any tax allowance in full. Institutional lenders provide the balance of the purchase price to the lessor on a non-recourse basis.

An extract from Christian Dior’s 2007 accounts illustrates how lease classification appears in practice:“In addition to leasing its stores, the Group also finances some of its equipment through long term operating leases. Some fixed assets and equipment were also purchased or refinanced under finance leases.”

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Sale and Leaseback

Extra financial reporting issues arise with sale and leaseback. An owner selling and leasing back an asset should in the first instance revise the recorded value of the asset to its economic value. This avoids distortion of the sale and leaseback transactions.

If the asset is sold at fair value and made the subject of an operating lease, any profit belongs in the year’s income statement. If the sale is above fair value, the purchaser will charge higher rentals. In this case, the seller’s profit on sale must be set against the high rentals by annual installments over the term of the lease or until the time of any rent review if sooner. If the asset is sold at a loss, the loss must be recognized immediately unless the purchaser compensates by below-market rentals, in which case the loss is amortized over the period of use. If the asset is sold at fair value and made the subject of a finance lease, any excess of proceeds over recorded value is amortized over the term of the lease.

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Tax

Significant tax changes will come with new accounting standards and increasing anti-avoidance legislation. Legislators and avoiders dodge and weave around pitfalls and opportunities. Management has to monitor and even try to influence discussion and hope that anti-avoidance provisions will not be retrospective.

In the United Kingdom, current detailed regulations1 as administered by HM Revenue and Customs tend to look to the accounting standards subject to the fundamental difference that the tax definition of finance lease is based on legal title. Thus, a taxable lessor can still pass the benefits of capital allowances to a nontaxable lessee in the form of reduced rentals. Other points include:

  • Finance charges are deductible according to any method that gives the lessor a constant return on rentals outstanding.

  • If premature termination occurs, individual circumstances will determine whether any payment is an adjustment of past rentals (revenue expenditure) or a penal charge (capital expenditure).

  • Any rebate or further rental arising on the substitution of one finance lease for another in respect of the same asset will also be a revenue item for tax purposes. Where an operating lease becomes a finance lease any transitional payment is treated as a revenue item.

  • Rentals on operating leases are tax-deductible.

The above general rules are subject to a continuing stream of anti-avoidance legislation. For example, on November 13, 2008, the UK government announced that it would take action, effective from that date, to prevent a loss of tax on transactions involving the leasing of plant or machinery under long funding leases, on the sale of a company that is an intermediate lessor of plant or machinery, and on rents payable on long funding leases of films.

Anti-avoidance legislation has countered many traditional tax benefits of leasing such as deferral of income, conversion of income into capital, acceleration of capital allowances, and techniques connected with sales and leasebacks. The cat and mouse anti-avoidance game becomes particularly frenetic when it crosses borders. This arises with double-dip leasing, when differing tax treatment of lessor and lessee under different jurisdictions generates allowances in each country. Anti-avoidance has closed off many such opportunities, and the taxpayer’s defeat in the Coleman case (see Case Study) illustrates both the complexity of the taxpayer’s attempt and the taxpayer’s vulnerability.2

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Case Study

Coleman

The British Tax Court imposed the strong proof rule on the taxpayer to show that it was entitled to depreciation deductions on a double-dip leasing transaction, even though the transaction was structured to also obtain a UK tax advantage. Coleman involved a cross-border leasing transaction, in which the parties sought to obtain depreciation deductions on certain leased computer equipment for both UK and US tax purposes. The lease and title to the computer equipment were transferred by a dealer to UK lenders, who were able to write off the computers in one year under UK tax law. The dealer retained an interest in the residual of the lease and (to simplify matters greatly) sold a portion of the residual interest to the US taxpayers. These persons claimed to be the owners of the leased computer equipment for US tax purposes and depreciated their bases in the equipment for US tax purposes. The court held that the record failed, under the strong proof standard, to sustain the petitioners’ position that they were the owners of the computer equipment, and that the form of the transaction as a financing should be disregarded.

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Open Issues

Much will be resolved when the new international standards appear, but in the meantime companies should monitor the IASB’s discussions of open issues. Sensitive areas under discussion include the following.

Right of Use

The Board favored reporting the lessee’s right of use during the term and the accompanying obligation to make specified payments. This seemingly innocuous definition amounts to a preference for a model that does not take account of an obligation to return the physical item. This may be insignificant for a long lease, but is material for a shorter lease.

Measurement of the Lessee’s Asset and Liability Under the Lease

The Board decided to recommend that right to use should be initially measured at the present value of the “expected lease payments.” They noted that these may differ from minimum lease payments if they include contingent rentals. The discount rate used in calculating the expected lease payments should be the secured incremental borrowing rate.

Options to Extend or Terminate a Lease

The Board decided to propose that options to extend or terminate the lease should be based on an assessment of the lease term, but it did not express a preference among the various frameworks for assessment, for example, a probability-weighted approach, or as to whether the estimated lease term should be trued up on a regular basis. There was a consensus that all contractual, noncontractual, financial, and business factors should be taken into consideration when determining the lease term.

Purchase Option

The Board favored inclusion of the purchase option if exercise of the option was the most likely outcome.

Residual Value Guarantee

The Board decided to propose that the lessee’s liabilities should include the obligation to make payments under a residual value guarantee.

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Making It Happen

Classification and treatment should not dominate the leasing decision. They should be integrated with the decision to achieve an optimal capital structure, including optimal financial mobility. Six important lessons emerge from the present review:

  • It remains important to choose between an operating and finance lease contract, but discussions regarding the revised international standard and evolving national standards must be carefully monitored to see how best to contract the lease.

  • Opportunities should be taken to contribute to the discussions, especially if there is a chance to head off a result that will harm the company’s interests.

  • The tax impact of a leasing decision under current provisions is crucially important.

  • Probable changes of tax treatment in response to the new standard must be monitored.

  • Anti-avoidance legislation must be anticipated as far as possible—the content of tax cases may provide a first indication.

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Notes

1 HM Revenue and Customs documentation, notably BIM61101–BIM 61185; BLM 00050–38000.

2 Coleman v. Commissioner, 87 T.C. 178 (1986).

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Further reading

Books:

  • Epstein, Barry J., Ralph Nach, and Steven M. Bragg. GAAP 2009. 6th ed. Hoboken, NJ: Wiley, 2008.
  • International Accounting Standards Board. International Financial Reporting Standards IFRS 2008: Including International Accounting Standards (IASs) and Interpretations as approved at 1 January 2008. London: IASB, 2008.

Articles:

  • Beattie, V., A. Goodacre, and S. J. Thomson. “International lease-accounting reform and economic consequences: The views of U.K. users and preparers.” International Journal of Accounting 41:1 (2006): 75–103.
  • Frecka, T. J. “Ethical issues in financial reporting: Is intentional structuring of lease contracts to avoid capitalization unethical?” Journal of Business Ethics 80:1 (2008): 45–59.
  • Henry, E., O. J. Holzmann, and Y. Yang. “Tracking the lease accounting project.” Journal of Corporate Accounting and Finance 19:1 (2007): 73–6.

Websites:

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