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HMRC internal manual

Business Leasing Manual

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HM Revenue & Customs
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Lease accounting: lease classification: borderline issues, accounting history

SSAP 21 sets out a principled test that defines a finance lease, supported by a largely arithmetical test to help define the borderline between finance leases and operating leases. When SSAP 21 was introduced in 1984 the intention was that the SSAP 21 borderline between finance and operating leases would be applied with common-sense and in the light of its spirit.

However its spirit was not adhered to by those who wished to adopt an essentially mechanical approach to the rules, in order to present the commercial accounts in the best possible light. For example, if a lessee wanted a lease to be an operating lease it could structure it so that the present value of the minimum lease payments amounted to only 89% of the fair value of the asset. Whether or not the lease was a finance lease then becomes a matter of professional judgment.

In 1994 the Accounting Standards Board issued Financial Reporting Standard 5: Reporting the substance of transactions (‘FRS 5’). Of particular relevance is Application Note B on sale and repurchase agreements, see BLM10020.

In particular, FRS 5 may oblige the parties, in appropriate cases, to recognise that they have a finance lease and not an operating lease. When there is a finance lease the parties must follow SSAP 21. Note that FRS 5 doesn’t change the SSAP 21 accounts presentation itself, it just requires certain transactions to be accounted for as finance leases on the basis that, in substance, that is what they are.

International Accounting Standards do not contain a separate standard that is equivalent to FRS 5. However there are rules that give a similar effect. For example

  • paragraph 10 of IAS 17 requires that classification of a lease as a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract
  • SIC-27 ‘Evaluating the substance of transactions involving leases’, see BLM10035 
  • IFRIC 4 ‘Determining whether an arrangement contains a lease’, see BLM10025.

In practice this means that in most cases a transaction that is treated as a finance lease under SSAP21 is also treated as a finance lease under IFRS and FRS101.

For those UK GAAP entities adopting FRS102, Section 20 paragraph 5 requires that classification of a lease as a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract - this is the same as IAS 17. However, unlike for IAS 17, there is no extra guidance to support FRS102. Entities choosing to adopt FRS102 in accounting periods beginning before 1 January 2015, and entities mandatorily adopting FRS102 in accounting periods beginning on or after 1 January 2015, will not be able to refer to FRS5.