When is a lease not a lease? Accounting considerations under the amended FRS 102

Except for entities with “finance leases” under the current accounting framework, in practice there was often little attention paid to analyse in detail a leasing arrangement on whether, or not, it was in actual fact a “lease” (i.e. operating lease) as 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, with the requirement to bring all leases on 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.

So, when is a lease not a lease? Or, when is a lease not accounted for on a balance sheet as a lease? The answer is:

1. When it’s actually a licence

Sometimes, agreements that appear to be leases are in fact licenses. A licence gives the licensee permission to use a property without transferring control. A good example would be a coworking office space where the user has the right to access a set amount of space in an office, often defined by the number of desks or a certain amount of floor space, rather than a specified area or floor in a building.

By design, licences tend to be temporary, with revocable permissions which 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 they 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 so when considering 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 respect of short-term leases (with a lease term of 12 months or less) and leases for which 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, 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.

One example would be where lease payments are dependent on the future performance or use of a piece of machinery. Even if the lessee is able to 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.