Study Zone

A matter of substance

It’s vital that you understand the concept of lease accounting. Here Martin Jones explains a topic you are very likely to be tested on

Lease accounting is a subject frequently examined by examiners for ACCA, CIMA, ICA and others, and it lends itself well to an article that you can read while you are bumping along on the bus or being buffeted by fellow commuters on the tube. This is because IAS17 leases has conceptual foundations that I can show you without need for me to use numbers or you to pull out your calculator.
That concept is called ‘substance’ and its single word nickname comes from the fundamental idea that financial reporting should report the substance of the transaction rather than the legal form. In other words, we should tell it how it is rather than how it appears. This particular application of substance uses a trick called ‘risks and rewards’. Again, this is a short form name for the idea that the person who really owns an asset is the one with substantially all the risks and rewards.
Lease contracts
So what has this got to do with leases? Well, lease contracts involve me (the legal owner or “lessor”) giving the use of an asset to you (the user or “lessee”) while keeping legal ownership. Note that I keep legal ownership. So it certainly appears the asset is mine. But that is the point. It is irrelevant that it appears that the asset is mine, what is important is who has the risks and rewards.
Car rental
Let us talk through a couple of rental contracts so that you get a feel for this idea played out in practice. Let us say I rent my flaming red Ferrari to you. If I rent my car to you for a week and I say that you can return it in any condition, then obviously I retain the risks and rewards of ownership of the car (as well as retaining the legal ownership). This is because you have the reward for a week, but thereafter it comes back to me and I can do what I like with it. More obviously, because of my rather daft agreement to you returning the car in any condition, I face the risk that you may have a crash. So IAS17 would tell me the car is still mine, even while you are driving it around. But if I rent my car to you for ten years, knowing that when it returns it will be scrap, and say that you are responsible for anything that happens to the car during that time; well you must admit, that is entirely different. IAS17 would say that I have transferred the risks and rewards of ownership to you and the car is effectively yours, even though I remain legal owner.
Lease accounting
The names used for lease accounting focus on you, not me. The second contract transfers the risks and rewards of the asset to you, so IAS17 requires you recognise the asset when you take the keys. To retain the balance on the balance sheet you also must recognise a corresponding liability, usually called the “finance”. So this is called a “finance lease”.
The first contract leaves risks and rewards with me. So you cannot recognise an asset, because the car is not yours, because I have the risk and rewards, not you. In fact, you recognise nothing on the position statement. Instead, the payment that you make goes straight to the income statement as an “operating” cost. So this is called an “operating lease”.
IASB
But as mentioned in last month’s ‘News from the Ivory Tower’ article, all of the above, although terribly impressive for wowing that pretty fellow student you have your eye on, vastly over complicates lease accounting. The International Accounting Standards Board (IASB) have a development project proposing a new standard based on one form of lease accounting focussed on the obligation, not the asset. So my advice is study hard, or you will have to learn some new lease accounting before you qualify.
• Martin Jones tutors at LSBF

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