BLM13010 - Lease accounting: finance lease accounting: outline

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.

This section is applicableÌýto entities applyingÌýFRS 102 pre 2024 amendmentsÌýor FRS 105, and for lessors only under IFRS 16 and FRS 102 (2024 amendments).Ìý

See BLM17000Ìýfor lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments).Ìý

Accounting standards for leasingÌýwere introducedÌýto address the problem of what is commonly referred to as ‘off balance sheet financing’.ÌýOne of the main aims of such arrangements is to finance a business’s assets and operations in such a way that the finance is not shown as a liability in the business’s balance sheet. A further effect is that the assets being financed are excluded from the accounts, with the result that both the resources of the entity and its financing are understated.Ìý

Therefore, accountantsÌýmustÌýlook at the commercial reality and treat a finance lease much as if it were a loan by a lessor to a lessee which the lessee uses to buy the asset. That is, the accounting follows the substance of the transaction rather than its legal form.

FinanceÌýlessorÌý

A finance lessor's accounts show no physical asset in its balance sheet even though it owns the leased asset. Instead,Ìýthe lessor shows its financial investment in the lease (in substance, the 'loan' outstanding) as its asset.Ìý

The ‘loan’ is equal to the remaining capital instalments due under the lease. At the outsetÌýthe 'loan' will generally beÌýequal to the cost of the asset bought by the lessor. TheÌýfinance lessor's earnings are the 'interest' on the loan (the interest element in the rentals):Ìý

  • the capital element in the rentals is the ‘loan repayments’ which go to the balance sheet to write down the debt;Ìý

  • the 'interest' earnings are allocatedÌýto each year in proportion to the outstanding debt in each year, resulting in higher ‘interest’ earnings in the earlier years of the arrangement.ÌýThe ‘interest’ is recognised in profit and loss.

Finance lesseeÌý(applicable to FRS 102 (pre 2024 amendments) and FRS 105 only

The finance lessee does not own the asset but shows it in its balance sheet as if it did (which is the economic substance if not, technically, the legal position).ÌýÌýÌý

The finance lessee also shows the capital owed to the finance lessor as aÌýliabilityÌýinÌýits balance sheet.Ìý

In its profit and loss account the finance lessee:Ìý

  • chargesÌýthe 'interest' element in the rentalsÌýto profit and lossÌýin the same way as any other loan interest,Ìý

  • does not charge the capital element in the rentals: they are treated as loan repayments which go to reduce the debt to the finance lessor included in the balance sheet,ÌýbutÌýinstead charges depreciation on the asset.Ìý

The timing of the deductions is important. For finance leases:Ìý

  • the interest is deducted by the finance lessee as it accruesÌýwithÌýmore interest due earlier reflecting the higher liability earlier in the term; andÌý

  • theÌýdepreciation deduction depends on the life of the asset or the life of the lease if there is no certainty that the lessee will obtain ownership of the asset. Depreciation is calculated in accordance withÌýthe relevant accounting standard.ÌýÌý

ÌýOff balance sheet finance remainsÌýavailable using specialised operating leases, see ÌýBLM11216.Ìý

The accountancy treatment has no effect on the ±ô±ð²õ²õ´Ç°ù’sÌýentitlement ÌýtoÌýclaim capital allowances (which depends on the legal ownership) except where the lease is a long funding lease, see BLM20000Ìýonwards, or falls within CAA01/S67, see BLM39000Ìýonwards.Ìý

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