When is a lease not a lease under FRS 102?

It is important to note that not all lease arrangements qualify as leases for accounting purposes. Certain contracts may fall outside the scope of lease accounting if they do not convey the right to control the use of an identified asset. Businesses should carefully assess the substance of the agreement to determine whether it meets the definition of a lease under FRS 102 Section 20 Leases.

When is a lease not a lease under FRS 102?

Except for entities with ‘finance leases’ under the extant accounting framework, in practice often little attention has been paid in analysing whether or not an arrangement is in fact a ‘lease’ for accounting purposes. This is because the accounting treatment for operating leases was often similar to that for other non-lease rental arrangements, where lease payments are expensed on a straight-line over the lease term.

However, as the new requirements of FRS 102 Section 20 Leases brings more leases on to the balance sheet, identifying whether an arrangement is, or contains, a ‘lease’ now becomes important.

A lease is now defined as a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

When is a lease not a lease? Or, when is a lease not accounted for on the balance sheet as a lease under FRS 102?

1. When it’s a licence

Sometimes, agreements that appear to be leases are in fact licenses. A licence gives the licensee permission to use property without transferring control. An example is a coworking office space, where users have the right to access a set amount of space in an office, often defined by the number of desks or a specific floor space, rather than a designated area or floor in a building.

By design, licences tend to be temporary. Revocable permissions do not provide the user with exclusive use and as such, there is no right to control the identified asset. Hence, there is no lease.

2. When there is a substitution right

Even if an asset is specified in the terms of the contract, there is no identified asset if the supplier has a substantive right to substitute the asset throughout the period of use. A substantive right to substitute an asset exists where the supplier has both the practical ability to substitute alternative assets throughout the period of use and would benefit economically from the exercise of its right to substitute the asset.

In the first part, although contracts containing substitution rights may not be unusual - for example, in the case where the supplier can exchange one car for another vehicle from their fleet - determining whether or not the substitution rights are substantive will often be critical in deciding whether a contract is or contains a lease.

If a substitution right was only exercisable upon the occurrence of a specific event, or after a period of time had elapsed, or on a specific date, the substitution right would not be substantive. However, determining when the supplier would economically benefit from the substitution may take a greater degree of analysis and judgement, particularly when considering that such an analysis would often be a responsibility of the lessee, who very likely wouldn’t be privy to the economic situation of the lessor.

3. When they are a short-term lease or a lease of low-value assets

A lessee can elect not to apply the lessee accounting model to short-term leases (with a lease term of 12 months or less) and leases where the underlying asset is of low value when it is new. Under the exemption, these leases would be accounted for in the same way as an operating lease, i.e. on a straight-line basis over the lease term.

Low value is not defined in FRS 102 Section 20 Leases, so there is the possibility of applying the IFRS guideline of $5,000.

4. When the consideration is variable

Variable lease payments that do not depend on an index or rate and are not, in substance, fixed are not included as lease payments in the measurement of the lease liability. As such, if the entire lease payment is variable, there is no lease liability recognised at the lease commencement date. Instead, the variable lease payment will be recognised in profit or loss on an accrual basis as the service is received.

For example, where lease payments are dependent on the future performance or use of a piece of machinery. Even if the lessee can estimate the level of performance or use that is highly probable to occur, the lessee should still consider the lease payments to be variable and exclude them from the measurement of the lease liability.

How to prepare for FRS 102 lease accounting changes

Assessing whether a contract is, or contains, a lease is usually straightforward. However, in practice, we have seen the emergence of more complex arrangements that require the application of significant professional judgement, particularly with respect to determining whether there is an identified asset, but also in some other areas. These judgements are increasingly focused on determining whether substitution rights are substantive, which requires careful consideration of the terms of each arrangement.

Our FRS 102 specialists understand that lease recognition, under updated accounting standards, is more than just a compliance exercise. A thorough understanding of the contractual terms and a careful application of FRS 102 section 20 are essential to ensure accurate financial reporting.