If you are a charitable organisation or group with operating leases for charity shops, a housing portfolio, or a fleet of vehicles etc, then this blog is to help you understand the proposed changes coming in for lessees and how this will impact your balance sheet in the future.
What is proposed?
On 15 December 2022, the Financial Reporting Council issued FRED 82, which is a consultation document setting out proposed changes to Financial Reporting Standard 102 (FRS 102). The consultation period is open until 30 April 2023. Ultimately, the proposed changes will apply to periods commencing on or after 1 January 2025 (early adoption may be possible).
One of the biggest changes, which has been in discussion for a number of years now, is to align FRS 102 to the equivalent international standard on accounting for leases (International Financial Reporting Standard (IFRS) 16 Leases). In very general terms, this means that lessees with operating leases will bring onto the balance sheet an asset and a corresponding liability reflecting the organisation’s right of use of that asset.
There will be some exceptions relating to:
- short term leases (less than 12 months); and
- low value assets such as electrical items (tablets, computers, printers, phones) and other small items of equipment, furniture or tools
regardless of whether these are material to the lessee. Cars, vans, larger items of equipment and land and buildings will all be covered by the new proposed treatment.
How do you identify a lease and the relevant lease term?
A lease is identified when you have a contractual right to use an asset and obtain substantially all of the economic benefits. The economic benefits could include using an asset for your own purposes, holding it to generate income, or sub-leasing it to another party.
The lease term includes any rent free periods, and in a similar way to how you prepare your lease commitment disclosure now, includes the aggregate of the non-cancellable element of the lease, plus any options to extend or terminate the lease depending on how certain you are to exercise the options.
How do you measure or value the asset and the liability?
At the start of the lease, you will recognise a right of use asset and a lease liability on your balance sheet.
In terms of initially measuring the asset, the cost will be equivalent to the measurement of the lease liability, plus any other initial lease payments, costs or incentives incurred at or before the commencement of the lease.
Coming up with a measurement value for the lease liability is a little more complex, and for anyone that likes to avoid discounting back to get a net present value then you will be disappointed!
Initially, you need to work out the present value of the lease payments that are not paid at the start of the lease. The present value is today’s equivalent value of a future transaction. These payments include fixed and variable payments, and other unavoidable payments that may be due under guarantees, purchase options, and penalty clauses, again based on what is expected to happen.
The discount rate to use is the interest rate implicit in the lease. You will need to work out what this is – there are options use to use the relevant borrowing rates, or if these are not readily determined, you can use the ‘gilt rate’ which is based on the yields linked to UK Government Securities.
If you qualify as a public benefit entity under FRS 102, you can choose to replace the above borrowing or gilt rates with the rate of interest obtainable on their deposits held with relevant financial institutions.
After the initial measurement, any variations to lease payments during the lease term will subsequently change the measurement of the lease liability and be recognised in the income and expenditure account (Statement of Financial Activities).
What are the accounting implications?
The most likely option for the asset is that you will recognise it on the balance sheet and use the ‘cost model’, so you will depreciate the asset and need to check it for impairment at each balance sheet date, as you would with other similar fixed assets. One trigger for the impairment of a right of use leased asset would be if you determine that you have an onerous lease.
When you set your depreciation policy, you will need to think about whether the asset has a useful economic life. If you have an option to purchase the asset at the end of the lease, then you will depreciate over the whole life of the asset. If there is no option to purchase, then you will depreciate over the shorter of the life of the asset or the lease term.
If the asset is an investment property, then you will recognise this using the ‘fair value model’ as you would with other investment properties and the asset will be subject to revaluation at fair value at each balance sheet date.
In terms of the liability, this will reduce each year by the cash payments that are made to settle the liability. There is likely to be interest on the lease, in which case the interest payments will increase the carrying amount and be a charge to the I&E account / SOFA in the year.
If there are any variations to the lease payments, or lease modifications, then you may need to remeasure the liability, and these might also impact on the discount rate that has been used in the initial measurement.
Right of use assets are required to be presented separately on the balance sheet or in the notes to the accounts. Lease liabilities are also required to be presented separately, or disclosure included to state in which line items in the balance sheet they are included.
Why might this be important for your organisation?
Your result for the year will be impacted by:
- A reduction in the operating lease payments that would have originally been expensed (excluding the interest element which will still be a charge to I&E)
- An increase in depreciation and potentially impairment charges for any assets recognised under the cost model
- Revaluation gains and losses for any assets recognised under the fair value model
In terms of your balance sheet, your total assets (fixed assets plus current assets) will increase which may impact on your size (if you are a company) and may require you to have an audit where you were not subject to this requirement previously.
You may also have borrowings with financial covenants, and these will be affected both by asset ratios and the impact on your result for the year as above – do consider these and discuss the impact in advance with your provider of finance.
You will want to think about how this impacts on your overall reserves position and how best to explain this in the trustees’ annual report and demonstrate the financial impact in the notes to your accounts.
The position for lessors remains relatively unchanged, other than intermediate lessors should review any sub-leasing arrangements to see whether they need to be accounted for as operating or finance leases under the proposed rules.
Any sale and leaseback arrangements previously entered into should not be reassessed in terms of whether it should have been accounted for as a sale. The arrangement should be considered according to whether it was initially a sale and finance leaseback or sale and operating leaseback. Please refer to the detailed rules for these specific considerations.
Where to go for help?
The above is very much a summary of the detail within the proposed exposure draft, so if you do think you are affected and want to read more about this, then the technical detail can be found here. Should you wish, you can respond to the consultation before 30 April 2023.
You can also contact me directly with any questions via our website.