The current picture
Academy trusts are very aware of the important distinction between finance leases and operating leases, since finance leases require prior approval from the ESFA before these can be taken out. In practice, it is rare for approval to be granted for such leases, even where the trust can afford the lease, and entering into it is clearly in the trust’s interests.
From an accounting perspective the classification of the lease is also important, although not necessarily straight forward. This is often not helped by lease companies promoting leases as an operating one, when in substance it could be a finance lease.
In essence a finance lease is classified as such if it transfers substantially all the risks and rewards incidental to ownership. All other leases are operating leases.
Under older accounting rules, a simple 90% test applied, however, some years ago FRS 102 removed the presumption that a lease would be a finance lease if the present value of the minimum lease payments amounts to 90% or more of the leased asset. For a number of years it has therefore not been this clear cut. When considering the type of lease and whether the risks and rewards of ownership have transferred, it is necessary to review whether:
• the lease transfers ownership of the asset to the lessee by the end of the lease term;
• the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
• the lease term is for the major part of the economic life of the asset even if title is not transferred;
• at the inception of the lease the present value of the minimum lease payments amounts to at least substantially (i.e. more subjective than the old 90% threshold) all of the fair value of the leased asset;
• the leased assets are of such a specialised nature that only the lessee can use them without major modifications;
• if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
• gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee (e.g. in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and
• the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
Therefore, there is lots to consider and each of these are not always completely clear. It is therefore little wonder that the treatment of leases is such a confusing area.
What is changing?
International accounting rules (IFRS 16) have already altered the approach for entities applying these standards, by eliminating a lessee's classification of leases as either operating, or finance leases. Instead, almost all leases are 'capitalised' by recognising its liability and right-of-use asset on the balance sheet.
International standards slowly flow through to UK accounting practice, and so in time this same rule will apply in the UK, removing the ‘off balance sheet’ reporting that currently applies to operating leases.
In response to these changes, in March 2022, the ESFA announced changes around the leasing rules that were due to take effect from the 1st of September 2022, which would leave trusts able to purchase certain assets under finance leases if they were included on the ESFA published list of permitted items.
The ESFA have now announced that these changes have been delayed until at least 1st of September 2024, in response to an overall delay in the governmental adoption the new accounting standard.
This means that the current rules will apply until at least this date, and that no finance leases are permitted except with the permission of the ESFA.
It is therefore important that academy trusts continue to assess any new leasing arrangements to determine if they are operating or finance in nature.
If you are unsure, or just need some guidance, then please contact your local UHY academy expert.