In this section on leases we shall look at two types of lease agreement where the normal treatment described in section 5.07 does not have to be applied. We shall also look at how the alternative treatment that may be used for these leases.
Normally, when a company enters a lease agreement, a company will record an asset which will then be depreciated and a lease liability that will be repaid over the lease term.
A lessee may however, elect not to apply these normal lease rules for:
- Short-term leases
- Leases for which the underlying asset is of low value
If the normal rules are not used for a particular lease, the company will instead record the cost of the lease as an expense on a straight-line basis. This means that the cost of the lease will be spread evenly over the period of the lease.
A short-term lease is one that has a lease-term of 12 months or less at the commencement date. Note that a lease that contains a purchase option is not a short-term lease.
A company should apply the same treatment for all short-term leases in the same class of underlying asset. For example, if a company has previously treated all short-term leases of IT equipment as expenses, it should continue to do so when a new item of IT is obtained using a short-term lease.
A company leases a cargo ship for a period of 9 months at a rate of £75,000 per month paid over the lease term.
As the lease term is less than 12 months the company will have the choice of treating the lease payments as expenses or alternatively of recording a leased asset and a lease liability.
A company has signed a lease for a piece of equipment. The lease period is 12 months at the end of which the company has the option of purchasing the equipment for a nominal fee. The company has no other leases. Will the company be allowed to treat the lease payments as expenses using the straight-line method?
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Although the lease period is 12 months it includes a purchase option. As such the alternative treatment may not be used and the company must use the normal accounting treatment for leases by recording a right-of-use asset and a lease liability
Leases for which the underlying asset is of low value
Where the value of the underlying asset is low, the company doesn’t have to use the normal lease rules and may elect to treat the lease payments as expenses on a straight-line basis.
What is meant by “low value”?
IRFS 16 does not specify a monetary amount below which an asset would be considered low value but it does provide a variety of assets that would qualify as being of low value. These include:
- Tablets and personal computers
- Small items of office furniture
The above examples suggest that the standard setters regard a few thousand pounds as being of “low value”. It is worth noting that this threshold would not be higher for larger companies.
Lastly, when we determine whether the underlying asset is of low value, we must use value of the asset when it was new, not its value at the commencement date of the lease.
Illustration 1 Low value leases
A company has entered into an agreement to lease a new laptop computer for a period of 24 months. If the laptop was purchased outright it could be bought for £2,750.
As the underlying asset is of low value the company has the option of treating the lease payments as expenses or of recording the laptop as an asset and recording a lease liability.
Illustration 2 Cost of the underlying asset when new
A company enters into a lease agreement to obtain the use of a vehicle for 36 months. The vehicle is several years old and a similar vehicle would cost around £3,000 to buy but when it was new it would have cost £15,000.
Although the underlying asset’s current value is low the company should consider its cost when new (i.e. £15,000). The original cost is not of low value so the company must apply the normal leasing rules and record an asset and a lease liability.
A company has entered two lease agreements. The first is a two year lease for a new water cooler which would cost £950 if purchased outright. The second is a two year lease for a new photocopier which would cost £6,999 to purchase outright.
How should each lease be treated in the company’s financial statements?
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The water cooler lease is a lease where the underlying asset is of low value. The company can therefore treat the lease payments as expenses on a straight-line basis or alternatively can record a right-of-use asset (which will then be depreciated) and a lease liability (on which interest will be calculated and will be repaid over the lease period).
The photocopier lease is not a lease where the underlying asset is of low value. The company must therefore initially record a right-of-use asset (which will then be depreciated) and a lease liability (on which interest will be calculated and will be repaid over the lease period).
Illustration 3 The straight-line basis
A company enters into a three year lease for a new desk which would cost £1,500 if purchased new. As the underlying asset is of low value the company elects to treat this lease as an expense on the straight-line basis.
The payments to be made under the terms of the lease are as follows:
- No payments will be made for the first six months
- Then 30 monthly lease payments of £60 each will be made
Charging the expense under the straight-line method means that the lease costs will be spread evenly over the lease term.
- First, calculate the total to be paid over the lease-term: 6m x £0 + 30m x £60 = £1,800
- Second, calculate we will calculate the monthly charge: £1,800/36m = £50 per month
- We can then calculate the annual charge: £50 x 12m = £600
A company has a year end of 31st May. On 01/06/2019, the company signed an eighteen month lease for a new printer which would cost £1,800 if purchased outright. The lease payments to be made are as follows; nothing will be paid in the first three months, then £130 will be paid each month over the remainder of the lease period.
If the company decides to treat this lease as an expense, calculate the lease expense to be included in the company’s Statement of Profit or Loss for the years ended 31/05/2020 and 31/05/2021.
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- The total to be paid over the lease period is £1,950 (i.e. 3 x £0 + 15 x £130)
- The amount to be treated as an expense in the year ended 31/05/2020 is £1,950 x 12/18 = £1,300
- The remainder of £650 will be treated as an expense in the year ended 31/05/2021