Section 20 – Leases
Section 20 applies to all leases, including some arrangements that do not take the legal form of a lease but convey rights to use assets in return for payments. It deals with the recognition, measurement and disclosures of operating and finance leases.
The following leases do not come within the scope of Section 20:
- licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights (Section 23);
- the measurement of property held by lessees that is accounted for as investment property (Section 16);
- measurement of biological assets held by lessees under finance leases and biological assets provided by lessors under operating leases (Section 34); and
- leases that could lead to a loss to the lessor or the lessee as a result of non-typical contractual terms (Section 12).
What is new?
Section 20.15A states that lease incentives should be recognised over the life of the lease which differs from old GAAP as under SSAP 21 the lease incentive is recognised from the point of commencement to the first break clause in the lease. This will result in the credit being released to the profit and loss account over a longer period of time.
Section 20 requires disclosures of the total minimum lease payments under non-cancellable operating leases analysed into amounts payable within one year, between two and five years and more than five years. Under old GAAP, the amounts that were to be disclosed were next year’s commitments showing when the contractual term expires from the year end date.
If lease payments increase annually by fixed instalments intended to compensate for expected annual inflation over the lease period, the fixed minimum increment that reflects general inflation will be recognised as incurred. There was no detailed guidance under SSAP 21 so this may result in differences on transition if material.
Under Section 20 leases that could lead to a loss to the lessor or the lessee as a result of non-typical contractual terms are excluded from scope. There is no such scope exclusion under SSAP 21.
Under Section 20, initial direct costs are included on initial measurement, whereas, under old GAAP there was no requirement to include such costs. As a result, there may be differences on transition if direct costs are material. However, in reality, it is not likely to have a material impact.
What is different?
FRS 26 adopters under old GAAP were required to identify embedded derivatives in leases that were not closely related to the host. There is no such requirement under Section 20.
Section 20.3 brings into scope rights to use assets in return for payments within arrangements that do not take the legal form of a lease. There is no such guidance in old GAAP (SSAP 21) however, FRS 5 was followed which suggested the same treatment. It is likely there will be no differences as a result.
Section 20.4 details what constitutes a finance lease which includes the fact that it should be classified as a finance lease if it transfers substantially all of the fair value of the asset. However, there is no 90% test as was detailed in SSAP 21. Under previous GAAP there was a presumption that transfer of risk and rewards occurred if the present value of the minimum lease payments discounted at the interest rate implicit in the lease, amounts to 90% or more of the leased asset. It is unlikely that this will result in any differences as to whether a finance lease exists and should not result in differences on transition.
Under Section 20 the inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. This contrasts with old GAAP as the inception is the earlier of the time the asset is brought into use and the date from which the rentals first accrue. It will be very rare for differences to arise on transition unless there is specialist equipment being leased which is being constructed.
A leased asset should be accounted for at the lower of the fair value of the asset or the present value of the minimum lease payments, discounted at the interest rate implicit in the lease. This differs from old GAAP which stated that it should be measured at the minimum lease payments, discounted at the interest rate implicit in the lease.
Other standards affecting Section 20 where differences arise:
Section 29 – Income tax – Deferred tax will be required to be recognised on any lease incentive adjustments posted in the FRS 102 comparative year. It is likely corporation tax will have to be paid over on this over the next 5 years under the transitional arrangements.
Section 35 – Transition to FRS 102 – A first time adopter is not required to retrospectively adjust the deferred element for lease incentives in relation to lease incentive received before the date of transition. Instead the entity can continue to release the incentives received prior to this date up to the break clause (i.e. continue to use GAAP rules). Note however where lease incentives have been received in the comparative years’ figures, the leasehold incentives will have to be recalculated such that it is release over the life of the lease. A first time adopter may also elect to assess whether an arrangement containing a lease exists at the date of transition as opposed to looking at the facts when the arrangement was entered into.
What are the key points?
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership.
A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership (Section 20.4).
A lease asset should be accounted for at the lower of the fair value of the asset or the present value of the minimum lease payments, discounted at the interest rate implicit in the lease.
Operating lease rentals should be charged to the profit and loss on a straight line basis.
Lease incentives are released over the life of the lease. Section 35 allows an exemption for leases entered into prior to the transition date.
Disclosure required showing the total commitments split into the period in which the obligation ceases.
Contingent rent is charged to the profit and loss as incurred.
In a sale and leaseback which does not transfer substantially the risk and rewards of ownership (i.e. the creation of a finance lease) the seller-lessee does not recognise immediately, as income, any excess of sales proceeds over the carrying amount. Instead, the seller-lessee defers such excess and amortises it over the lease term.
What do accountants need to do?
Get to grips with the changes likely as a result of the new standard.
Advise clients who regularly receive lease incentives of the need to release the credit over the life of the lease as opposed to the first break clause. Advise clients on the impact this will have on the client’s’ profit as well as the deferred tax adjustment on transition that will need to ensure that the financial statements comply with FRS 102. Advise that this will mean that the lease incentive will be taxed over a longer period of time.
What do Companies need to do?
Get to grips with the differences between Section 20 and old GAAP.
Identify the adjustments required to comply with Section 20 from the date of transition, particularly adjustments for lease incentives to include the deferred tax effect for the comparative year assuming the exemption in Section 35 is availed of.
Assess whether the impact of the requirement to include initial direct costs is material on the opening balance sheet.