BLM11216 - Lease accounting: lease classification: operating leases & off balance sheet finance

This manual is being updated to reflect FRS 102 (2024 amendments). For guidance on the tax treatment of accounts prepared under IFRS 16 or the revised FRS 102, please refer to pages within the BLM50000 chapter.

Operating leases, particularly on expensive assets, are often simply another form of finance. In these cases, the lessor takes some equity risk, but in substance it is still making a loan to the lessee. 

Leases that function as financing transactions may be properly classified as operating leases, but the lessor is likely to sell the asset at the end of the lease and so, as with finance leases, there may only be a single lessee. The difference is that, because the rentals do not fully cover the cost of the asset (plus interest), the lessor has to take some risk that the value of the asset at the end of the lease (the 'residual value') will not pay off that part of the 'loan' that is not, in effect, repaid via the rental stream. 

The advantages for the lessee include not having to pay for the full cost of the asset over the term of the lease and the fact that borrowing remains off balance sheet – hence operating leases may be a form of off- balance sheet finance. The latter is important for some businesses for commercial reasons (although not relevant for any lessee who has adopted FRS 102 (2024 amendments) or IFRS 16, which no longer distinguishes between operating and finance leases). The lessee may, however, pay what amounts to a higher rate of interest on what amounts to the loan, as well as losing any upside on the expected residual value at the end of the lease term. 

Example 

A lessor might acquire an asset for £50m and expect it to have a value of between £20m and £25m at the end of the lease term, with only a 5% chance the value will be less than £20m. The rentals may be calculated much as they are for a finance lease except that, rather than assuming little or no value at the end of the lease term, the asset is assumed to have a value of £20m. In this simple example the lease is broadly equivalent to a loan of £30m but there is a 95% chance the lessor will make a profit exceeding his interest return, and if the lessor has a portfolio of operating leases the risk of overall loss is very small. 

Although the lease is broadly equivalent to a loan of £30m the lessee will not benefit from any increase in value of the asset at the end of the lease term. If the asset has a value exceeding £30m at the end of the lease the lessee will have ‘lost out’; if the asset has a value of less than £30m at the end of the lease the lessee will have ‘won’ when compared to borrowing. 

This is very simple example to illustrate the point. Commercial pressures will force the lessor into competitive terms, and the taking of residual value risks (i.e. the risk that the value will be less than £20m in the example above) involves a high degree of skill and judgment because it may not be possible to limit the risk of loss as much as in this simple example. The risk of loss is real, which is a strong indication that the lease is an operating lease, but that does not mean the lease is not broadly commercially equivalent to a loan. If it were not, the term ‘off-balance sheet finance’ would be inappropriate and yet it is frequently encountered in connection with lease finance. 

Note that the schedules to operating leases of this type may set out the cost and implied residual value, much in the same way as happens with big ticket (high value) finance leases. That is, the arrangements between the parties are transparent, reflecting the underlying nature of the arrangement as a loan. 

A lack of transparency does not mean that the lease is not performing a financing function. Sophisticated lessees can carry out the calculations for themselves providing only that they know or can estimate both the cost and the residual value of the asset at the end of the lease term. 

In general, operating lease payments can be thought of as reflecting the market rate for leasing the asset concerned and not as containing an interest and capital element. 
 
However, operating lease rentals are not always based on the market rate for the asset concerned and such leases can function as financing transactions. 

Primary and secondary periods

Operating leases may have primary and secondary (and even tertiary etc) periods. 
 
Operating lease rentals payable in the secondary period are likely to be based on market rate for the asset concerned. For example, an airline might lease an aircraft for 5 years at $1m a month. At the end of the 5-year primary period, the lessee may have an option to extend the lease into a secondary period. The rents for this period might be fixed at (say) $800,000 a month to reflect the age of the aircraft. There would be no expectation, let alone compulsion, for the lessee to enter into the secondary period. 
 
The structure of an operating lease designed to perform a financing function may also contain primary and secondary (or more) periods. If the option to extend the lease into the secondary (or later) periods is exercised the rentals payable in each period will be designed (broadly speaking) to give the lessor a financial return. There are, however, likely to be complex arrangements which ensure that, in the event the lessee does not exercise the option to extend the lease term, the lessor faces minimal risks consistent with the lease being correctly classified as an operating lease.