Accounting for leasehold property in the UK A triumph of substance by pengxiang


									Journal of Corporate Real Estate Volume 3 Number 3

                                       Accounting for leasehold property in the
                                       UK: A triumph of substance over form?

                                       *Andrew Holt and Timothy Eccles
                                       Received (in revised form): 19th March, 2001
                                       Corresponding author: *Kingston University School of Accounting and Finance,
                                       Kingston Hill, Kingston upon Thames, Surrey KT2 7LB, UK;
                                       Tel: 44 (0)20 8547 2000, ex. 5204; Fax: 44 (0)20 8547 7087;

                                       Andrew Holt is a senior lecturer in the School      examines the conceptual framework in which
                                       of Accounting and Finance at Kingston Univer-       accountants view the existing lease reporting
                                       sity, UK. He co-wrote with Timothy Eccles the       provisions, examining the unease the current
                                       earlier paper ‘Accounting for Property in the UK:   provisions cause. Finally, it discusses the most
                                       The Legal and Professional Framework’.1 He          recent proposals and offers a commentary upon
                                       is co-author of the forthcoming ‘Property and       responses to them. It concludes with a warning
                                       Construction Accounting’.2                          to the owners and users of leasehold property
                                                                                           to be ready for change — or to make their
                                       Timothy Eccles is a senior lecturer in the          voices known.
                                       School of Surveying at Kingston University, UK.
                                       He co-wrote with Andrew Holt the earlier paper      Keywords: accounting standard, con-
                                       ‘Accounting for Property in the UK: The Legal       sultation, lease, leasehold, property
                                       and Professional Framework’. He is also a
                                       co-author of the forthcoming ‘Property and
                                       Construction Accounting’ and of the in-print        INTRODUCTION
                                       ‘Property and Construction Economics’.3 He is       The subject of leases has recently been
                                       editor of the journal Environments by Design.       discussed within two technical and com-
                                                                                           mercial contexts within the property
                                                                                           profession. First, the concept of the lease
                                       ABSTRACT                                            length has been discussed with a view to
                                       This paper is concerned with accounting for         replacing the traditional 25-year lease by
                                       leasehold property. While property professionals    shorter and more flexible alternatives.
                                       are familiar with commercial and technical          This is seen as a response to the
                                       aspects of leases, recent proposals offer serious   commercial needs of users willing to
                                       implications beyond the notional historical         reimburse property owners with higher
                                       reporting of an entity’s financial position.         payments for this flexibility. It was
                                       Current proposals issued by the ASB will            mooted by the ‘Right Space: Right
                                       markedly impact upon the financial posi-             Price?’ Reports for the Royal Institution
                                       tion reported by businesses holding leasehold       of Chartered Surveyors4 and variously
                                       properties, with consequent effects upon their      discussed in different forums along dif-
                                       reported profitability and their ability to raise    ferent commercial angles.5 Secondly, and
                                       finance. This paper examines the current             more recently, has been fought the
    Journal of Corporate Real Estate
    Vol. 3 No. 3, 2001, pp. 232–247.   position, whereby leases are regarded as either     popularly titled ‘Great Rent Review
      Henry Stewart Publications,
    1463–001X                          a finance or an operating lease. It then             Debate’ concerning the possibility of

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either regulation or code of practice for      nature of the lease that holds interest.
the upward-only rent review.5                  However, in order to give valuable infor-
   There is, however, a third subject that     mation, the accountant seeks to unravel
has recently been revisited concerning the     the substance of the transaction of the
lease, and that is the manner in which it      form, and by doing so attempts to report
should be accounted for. The following         in the accounts the actual financial im-
paper aims to examine the existing             plications of the lease. This is not always
situation as a means of explaining both        easy to achieve under the current ac-
current practice and the rationale for         counting rules.
proposed revisions to the existing ap-
proach. A future paper will examine the
responses received by the Accounting           PRESENT ACCOUNTING RULES:
Standards Board (ASB) as part of the           SSAP 21
formal process of creating a new standard,     The accounting rules9 governing lease
and the new standard itself.7 In ‘Account-     accounting are contained within Standard
ing for Property in the UK: The Legal          Statement of Accounting Practice (SSAP)
and Professional Framework’8 the authors       21, ‘Accounting for Leases and Hire Pur-
outlined the main issues surrounding the       chase Contracts’, which was issued in
valuation and reporting of owner-oc-           1984. In the accounts of a lessee, the
cupied property and tangible fixed assets       correct accounting treatment to adopt
in UK financial reports. The present paper      directly hinges on the application of a rule
builds on this and focuses on the different    that first attempts to establish whether or
accounting requirements when valuing           not all the risks and rewards of owning
and reporting leasehold property and           a leased property are transferred to the
other leasehold tangible fixed assets.          lessee. If the risks are transferred to the
                                               lessee, the lease is recorded as a finance
                                               lease, and the lessee has to record both an
LEASE ACCOUNTING: POLITICS AND                 asset and a liability in respect of the
PROBLEMS                                       payments the lease requires. In essence,
Historically, UK leasehold accounting has      this is basically akin to the situation where
been a highly sensitive and political issue,   the lessee itself actually purchased the asset
with different views and concerns ex-          outright in cash. If the risks and rewards
pressed by the accounting profession, the      of ownership are not transferred to the
legal profession, property companies and       lessee, the lease is classified as an operating
valuers. This is particularly evinced within   lease, and the only accounting needed by
the arguments that revolve around con-         the lessee is to include a note about the
cerns expressed about the ‘economic con-       operating lease commitments in the ac-
sequences’ of accounting standards for         counts. Thus the most important defini-
corporate performance. Furthermore, the        tions of SSAP 21 are as follows.
complex nature of leasehold contracts,            A finance lease is a lease which transfers
along with observed abuses and creativity      substantially all the risks and rewards of
in lease accounting practice, has led to       ownership of an asset to the lessee. It
immense concern about just how to es-          should be presumed that such a transfer of
tablish the accounting ‘substance’ of such     risks and rewards occurs if at the inception
contracts. For the lawyer, it is the legal     of a lease the present value of the mini-
form of the lease contract that matters.       mum lease payments (MLP), including
For the leaseholder, it is the commercial      any initial payment, amounts to substan-

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                             Table 1: Determining a finance lease

                             Process                                          Comment

                             (1) Calculate the total MLP inclusive of         MLP minimum lease payments plus any
                                 initial payment                                residual amounts guaranteed by lessee
                             (2) Determine the present value (PV) of the      Discount factor to use is either:
                                 total MLP                                      (a) Rate of interest implicit in lease; or
                                                                                (b) A commercial rate of interest
                             (3) Calculate the ‘fair value’ of the asset at   ‘Fair value’ the arm’s length price less any
                                 beginning of lease                             government grants receivable by lessor
                             (4) It is a finance lease if (2) amounts to 90%   This is the ‘rule of 90%’
                                 or more of (3)

                             tially all (normally 90 per cent or more)            lease payments (MLP) that the lessee has
                             of the fair value of the leased asset.               guaranteed to pay under the terms of the
                                An operating lease is a lease other than a        lease agreement. This calculation is shown
                             finance lease. An operating lease has the             in Table 1.
                             character of a rental agreement, with the               As an example of this rule, consider the
                             lessor usually being responsible for repairs         following simple lease agreement. A Ltd
                             and maintenance of the asset.                        leases a property from B Ltd on 1 January
                                If the lease is an operating lease, the           2000. £10,000 is payable immediately,
                             accounting for the lessee is simply to               followed by three annual payments on 1
                             charge the annual rental charge against the          January of 2001, 2002 and 2003. The
                             profit and loss account for the year. If a            agreed fair value of the property is £34,868
                             lease is determined by the rules of SSAP             and the interest rate implicit in the lease is
                             21 to be a finance lease, the resulting               10 per cent per annum. A Ltd has the right
                             accounting is much more complicated for              to continue using the asset at the end of the
                             the lessee. This will be discussed in more           three-year lease at no cost. The expected
                             detail below. In the accounts of the les-            useful life of the property is five years, at
                             sor, the accounting generally mirrors the            which time it will be worthless.
                             treatment of leases followed by lessees,                The present value of the minimum
                             with finance and operating leases being               lease payments is £10,000 plus the
                             reported differently in the accounts. The            present value of an annuity of £10,000
                             accounting disclosures required by lessors           paid for three years at a discount rate of
                             are also discussed below, although the               10 per cent per annum. In total this
                             emphasis of this paper is on the account-            comes to £34,868, which equals 100 per
                             ing for lessees.                                     cent of the fair value of the leased asset.
                                                                                  Thus, according to SSAP 21, this lease is
                             Identifying a finance lease under                     a finance lease.
                             SSAP 21: ‘The rule of 90 per cent’
                             The ‘rule of 90 per cent’ is the most                Finance leases
                             critical aspect of SSAP 21, since it serves
                             to identify what qualifies as a finance                Initial accounting entries
                             lease in the annual accounts. The criti-             For a lessee, at the start of the finance lease
                             cal factor is to calculate the minimum               both an asset and its counterbalancing

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Table 2: Allocating finance charge — actuarial method

            Capital sum                        Capital sum                    Capital sum
            at start of                        during the       Finance       at end of
Period      the period        Rental paid      period           charge        the period

2000        £34,868           £10,000          £24,868          £2,487        £27,355
2001        £27,355           £10,000          £17,355          £1,736        £19,091
2002        £19,091           £10,000           £9,091           £909         £10,000
2003        £10,000           £10,000            —                —             —

liability have to be entered into the ac-      tions using this method for the A Ltd
counting records. These entries are equal to   example are shown in Table 2.
the following.                                    Thus the total finance charge of £5,132
   The asset is the present value of the       is allocated during the term of the lease.
MLP and should be included as a fixed           Each individual rental payment paid is
asset in the balance sheet. In the A Ltd       split between paying the finance charge
example, this is £34,868.                      for the period (a profit and loss account
   The liability equals the obligations to     item) and repaying future obligations to
pay rentals under the lease. This will equal   pay rentals (thus reducing the balance
the present value of the rental payments,      sheet liability).
which again are £34,868.
                                               Accounting disclosures required for
Depreciation of the underlying lease           lessees: Finance leases
asset                                          All that remains is to discuss the account-
The related fixed asset should be               ing disclosures required for all types of
depreciated over the shorter of either the     leases under SSAP 21. For a lessee having
economic useful life of the asset or the       a finance lease these are as follows.
term of the lease (which is the period over
which the lessee uses the asset). For the A    Balance sheet: Fixed assets
Ltd example, this charge would be              Show by each major class of asset the
£34,868 spread over five years, equating        gross amounts of assets held under a
to annual depreciation of £6,974.              finance lease and any related accumulated
Allocation of finance charges
Over the lease term, the total finance          Balance sheet: Liabilities and obligations
charge is the amount by which the rentals      under finance leases
paid by the lessee exceed the present value    The amounts of obligations related to
of the MLP. From the A Ltd example, this       finance leases (net of finance charges allo-
comes to a total charge for finance of          cated to future periods) should be dis-
£5,132. The total finance charge should         closed separately from other obligations
be allocated in a fair manner over the         and liabilities, either on the face of the
term of the lease; this is normally done       balance sheet or in the notes to the
using the actuarial method. The calcula-       accounts.

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                                These net obligations under finance         Accounting disclosures required for
                             leases should then be analysed between        lessors: Finance leases
                             amounts payable in the next year,             From the viewpoint of the lessor, SSAP
                             amounts payable in the second to fifth         21 requires the following accounting dis-
                             years inclusive from the balance sheet,       closures in the lessor’s accounts.
                             and the aggregate amounts payable
                             thereafter.                                   Balance sheet
                                                                           The amount due from the lessee under a
                             Profit and loss account                        finance lease should be recorded in the
                             The total depreciation charge and ag-         balance sheet as a debtor at the amount of
                             gregate finance charges for the period in      the net investment in the lease after
                             respect of finance leases should be dis-       making provisions for items such as bad
                             closed in the profit and loss account for      and doubtful debts. From the earlier ex-
                             the year.                                     ample, for B Ltd this would have been
                               As an illustration, the disclosures re-     £34,868.
                             quired for the A Ltd example at 31st
                             December, 2000 are set out in Table 3.        Profit and loss account
                                                                           The total gross earnings under a finance
                                                                           lease should normally be allocated to
                             Accounting disclosures required for           accounting periods to give a constant
                             lessees: Operating leases                     periodic rate of return to the lessor’s net
                             According to SSAP 21, the accounting          cash investment in the lease in each
                             disclosures required for operating leases     period.10

                             Balance sheet: Obligations under              Accounting disclosures required for
                             operating leases                              lessors: Operating leases
                             In respect of operating leases, the lessee
                             should disclose in a note the payments        Balance sheet
                             that it is committed to make during the       The property or asset leased should be
                             next year. These payments should be           included as a tangible fixed asset. It should
                             analysed between those for leases in          be depreciated according to its estimated
                             which such commitments expire within          useful economic life.
                             that year, in the second to fifth years
                             inclusive, and over five years from the        Profit and loss account
                             balance sheet date. Commitments in            Rental income should be allocated using
                             respect of leases of land and buildings and   a straight-line method of allocation. Any
                             other operating leases should be shown        depreciation on the asset should be
                             separately.                                   charged as an expense.

                             Profit and loss account                        Disclosure of Accounting Policies
                             The total of operating lease rentals          One further disclosure is required for both
                             charged as an expense in the profit and        lessees and lessors: namely, the accounting
                             loss account should be disclosed, analysed    policy adopted as regards the treatment of
                             between amounts payable in respect of         leases in the accounts. This has to be
                             hire of plant and machinery and in respect    disclosed by way of a note to the ac-
                             of other operating leases.                    counts.

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Table 3: A Ltd disclosures for the finance lease during 2000

                                                                   £                £
Balance sheet as at 31st December 2000
Fixed assets
Leased property under finance leases:
Cost                                                               34,868
Less aggregate depreciation                                         6,974
Net:                                                                                27,894
Creditors: amounts falling due within one year
Obligations under finance leases*                                                     8,264
Creditors: amounts falling due after more than one year
Obligations under finance leases due within two to five years                         19,091
*The amount payable in 2001 is £10,000, but that includes a
finance charge not yet accrued at 31st December 2000 of £1,736
Alternatively, the creditors information could be disclosed
by a note to the accounts as:
Obligations under finance leases:
Due within one year                                                10,000
Due within two to five years                                        20,000
Less: finance charges allocated to future periods                   (2,645)

Profit and loss account for year ended 31st December 2000
Interest payable:
  Finance charges in respect of finance leases                       2,487
Depreciation                                                        6,974

ACCOUNTING PROBLEMS WITH THE                       in which it has been applied in the past in
SSAP 21 ‘RULE OF 90 PER CENT’                      an effort to get leases ‘off balance sheet’.
As might be expected, the ‘rule of 90              As will be shown in the next section, in
per cent’ contained in SSAP 21 does                1994 the ASB introduced another stan-
not always provide conclusive evidence             dard, FRS 5, aimed at supplementing the
about the correct accounting treatment to          deficiencies apparent in lease accounting
adopt. The risks and rewards associated            under SSAP 21.
with the ownership of an asset can pass in
other situations. A lessee could effectively       Greater lease complexity: The role of
control a leased asset without paying min-         FRS 5
imum lease payments that are equal to or           Since SSAP 21 was introduced in 1984,
exceed 90 per cent of the fair value of            the terms of many lease contracts have
the asset. As long as the lessee controls          become increasingly complex, often ex-
the leased asset, it effectively ‘owns’ it         hibiting characteristics of both a finance
and should show the associated asset and           lease and an operating lease. Because of
liability in its accounts. The ‘rule of 90         this, SSAP 21 relying exclusively on its
per cent’ cut-off was never meant to be            ‘rule of 90 per cent’, has become a
applied in a mechanistic way by account-           relatively blunt instrument for tackling the
ants, but that has tended to be the manner         accounting implications of leases. As was

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                             shown above, the approach of SSAP 21            requirement is that whenever a transac-
                             can be described as ‘all or nothing’ — that     tion is covered by more than one rule, the
                             is, a leased asset and related obligation to    most specific should be applied. With
                             pay rentals remain wholly off balance           SSAP 21, ‘Accounting for Leases and
                             sheet until the ‘90 per cent’ threshold is      Hire Purchase Contracts’, the position as
                             passed. At this point, the full fair value of   to which standard is the most specific
                             the asset and an equal liability come onto      is not entirely clear. The key question
                             the balance sheet.                              is whether the requirements of FRS 5
                                In an effort to improve both lease           always override those contained within
                             and other forms of accounting, FRS 5,           SSAP 21. FRS 5 states that:
                             ‘Reporting the Substance of Transactions’,
                             was issued by the ASB in 1994. FRS 5              ‘In general, SSAP 21 contains the more
                             was aimed at giving guidance on how to            specific provisions governing account-
                             account for complex transactions (such as         ing for stand-alone leases that fall
                             leases) where the: ‘true commercial effect        wholly within its parameters, although
                             of such transactions may not be ade-              the general principles of the FRS [5]
                             quately expressed by their legal form’.11         will also be relevant in ensuring that
                                FRS 5 applies where an existing stan-          leases are classified as finance or
                             dard is being openly flouted by exploit-           operating leases in accordance with
                             ing a technical interpretation of its words       their substance.’12
                             to override its ‘spirit’. The reasons be-
                             hind its introduction need to be put in         Consequently, SSAP 21 remains the
                             context. The FRS 5 standard arose as the        relevant accounting standard for dealing
                             ASB’s direct response to creative over-         with straightforward leases, but FRS 5 is
                             provision of future liabilities, costs and      the relevant accounting standard for
                             expenditures (dealing with re-organisa-         dealing with complex leases or leases
                             tion costs in this manner was very              which form part of a series of transactions
                             popular) by companies attempting to             (most notably where a sale and leaseback
                             smooth out their reported profits. As            arrangement is entered into). According
                             such, FRS 5 provides a framework that           to this quote from FRS 5, it seems that
                             attempts to force companies to report           where, for example, the ‘rule of 90 per
                             assets and liabilities in their accounts        cent’ test in SSAP 21 indicates that a lease
                             according to the underlying economic            should be operating, but in ‘substance’ the
                             ‘substance’ of the transaction that brought     lease is clearly finance, then FRS 5
                             them into being. In essence, for FRS 5,         requires SSAP 21 to be overruled.
                             the ‘legal form’ of a transaction is always     Obviously, this introduces an element of
                             secondary to the actual recording of its        accounting discretion into the treatment
                             economic ‘substance’. In terms of leasing,      of each and every lease held by a
                             the aim of FRS 5 is to force companies          company. Accountants must first appeal to
                             to record leases as finance leases if that       SSAP 21 and then check whether FRS 5
                             is their ‘true substance’.                      can offer any further guidance. In certain
                                Before attention is focused on the actual    situations this can make ascertaining the
                             rules and definitions contained in FRS           appropriate accounting treatment to adopt
                             5, it is important to ascertain how it          much more difficult.
                             operates alongside SSAP 21. FRS 5 gives            The approach taken by FRS 5 is en-
                             clear guidance on its relationship with         tirely different from that adopted in SSAP
                             other accounting standards. The general         21. Under FRS 5, a key step in report-

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ing the ‘substance’ of any transaction is      (1) there is sufficient evidence of the
to identify its effect on the assets and           existence of the item (including,
liabilities of the entity. Once it appears         where appropriate, evidence that a
from analysis of the transaction that either       future inflow or outflow of benefit
an asset or a liability has been ‘acquired’        will occur); and
by an entity, it simply remains to be          (2) the item can be measured at a
ascertained whether it should be included          monetary amount with sufficient
in the balance sheet. The definition and            reliability.
recognition of assets and liabilities under
FRS 5 utilises the same approach as later      In this way FRS 5 is aimed at capturing
adopted by the ASB’s ‘Statement of Prin-       the ‘substance’ over the mere ‘legal’ form
ciples for Financial Reporting’, issued in     of transactions such as leases. By doing so,
1995. According to FRS 5 a liability is        it tries to solve effectively the problem of
‘An entity’s unavoidable obligations to        accounting for leases where there is a
transfer economic benefits as a result of       separation of legal title from benefits and
past transactions or events’.13 Assets are     risks of ownership.
defined as ‘Rights or other access to              Finally, it now seems appropriate to
future economic benefits controlled by an       give a simple example of the relationship
entity’.14                                     between SSAP 21 and FRS 5. Consider
   Under FRS 5, an obligation to transfer      a three-year lease of a warehouse cost-
benefits must be evidenced by the exist-        ing £10,000 and having an estimated
ence of some circumstance by which the         residual value after three years of £3,000.
entity is unable to avoid, legally or com-     The present value of the rental payments
mercially, an outflow of benefits. Thus          is £7,000. At the end of the three-
FRS 5 emphasises the amount of liability       year primary lease period, the warehouse
that an entity expects to pay, which is the    is sold. If the proceeds are more than
present obligation that the entity is unable   £3,000, the lessee receives the profit.
to avoid. Where a transaction such as a        If the warehouse is sold for less than
lease includes an option to cancel, FRS 5      £3,000, the lessee bears the first £1,000
requires one to assume that the transac-       of loss, after which the lessor bears any
tion will be extended when there is no         further loss. The lessee guarantees £7,000
genuine commercial possibility that it will    of rentals, plus £1,000 of residual, which
not be, assuming that each party acts in       under SSAP 21 together are less than 90
accordance with its economic interests.        per cent of initial fair value — the lease
Thus FRS 5 goes beyond reporting the           would be accounted for as an operating
mere legal form of a transaction and           lease. In practice, the lessee is bearing all
attempts to show the commercial sub-           the risk that is likely to exist, and the lease
stance and ‘risks and rewards’ of a transac-   is finance in substance. According to FRS
tion. By doing so, it effectively prevents     5 the lease should be treated as a finance
many forms of ‘off balance sheet’ financ-       lease in the accounts, as both an asset and
ing.                                           a liability are created for the lessee under
   FRS 5 states that the liability and asset   the transaction. However, under FRS 5
definitions should be applied to each and       the lessee needs to capitalise the rights it
every transaction. Should a transaction        has acquired — that is, £7,000, being the
result in an item that meets either defini-     present value of three years’ use of the
tion, that item should be recognised in        warehouse. This amount of £7,000 is also
the balance sheet if:                          the unavoidable obligation of the lessee,

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                             so should also be shown as a liability in      daily pragmatic basis. However, the
                             the accounts.                                  classification of a lease has important
                                To summarise, the existing UK ac-           implications for the reported level of
                             counting rules on lease accounting are         corporate indebtedness, the calculated
                             contained in the SSAP 21 and FRS 5             gearing ratio, corporate borrowing ability
                             accounting standards. SSAP 21 contains a       and other commonly used measures of
                             ‘rule of 90 per cent’ that must be applied     performance. If, for example, a lessee
                             before a company accountant can as-            company could justify treating a finance
                             certain whether the lease should be            lease as an operating lease, it would then
                             capitalised on the balance sheet as a          effectively render the financial obligations
                             finance lease, or merely treated as an          of the lease contract ‘off balance sheet’,
                             operating lease. However, in situations        thereby excluding itself from having to
                             where the ‘substance’ of the lease is          show the financial liability of the lease on
                             finance in nature, FRS 5 applies and            its balance sheet at all. This ‘off balance
                             forces the company to capitalise on the        sheet financing’ is a long-practised form of
                             balance sheet the unavoidable obligations      creative accounting and is something that
                             and rights acquired from the lease. The        the ASB has been trying to prevent. Left
                             application of these rules is obviously at     unchecked, such abuses exaggerate the
                             the mercy and judgement of the in-             apparent attractiveness of companies and
                             dividual accountant, but it must be            mislead investors.
                             remembered that the accounts have to be
                             audited by an independent accountant           Lease accounting impact on reported
                             who checks for proper application of           performance: An example
                             relevant standards.                            The performance implications of lease
                                The introduction of FRS 5 has clearly       accounting can be illustrated by returning
                             cut a company’s ability to structure leases    to the example of A Ltd. Table 3 showed
                             in a manner which avoids the SSAP              extracts from the accounts at the end of
                             21 ‘rule of 90 per cent’. Without this         the first year of the lease if it was con-
                             safeguard, by having a lease classified as an   sidered a finance lease, with an asset and
                             operating lease a lessee is able to remove     an associated liability being shown in the
                             the liability associated from the balance      accounts. How would this form of ac-
                             sheet. The next section will examine why       counting affect certain measurements of A
                             this is so important and explain exactly       Ltd’s performance? Well, it would first
                             why ‘off-balance’ financing is common           depend on the existing capital structure of
                             and how it can affect reported accounting      the company before it signed the lease
                             performance.                                   agreement.
                                                                               Column 1 of Table 4 gives A Ltd’s
                                                                            balance sheet immediately prior to it sign-
                             IMPORTANCE OF LEASE                            ing the lease agreement with B Ltd,
                             ACCOUNTING FOR REPORTED                        where it had fixed assets worth £100,000,
                             PERFORMANCE                                    current assets of £20,000, no short-term
                             How lease agreements are reported in the       creditors and £20,000 of long-term debt.
                             annual accounts may appear relatively          Let us assume for simplicity that during
                             unimportant to the property professional       the year 2000 A Ltd gains £20,000 profit
                             more concerned with negotiating lease          in cash from trading.
                             length or dilapidation liabilities and the        If the lease with B Ltd is treated as
                             property user running a business on a          a finance lease, then, ceteris paribus, the

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Table 4: Performance measurements compared

                                        1                   2                     3
Date of balance sheet                   Prior to signing    At 31st Dec 2000      At 31st Dec 2000
Accounting treatment for lease          lease               As finance lease       As operating lease

Balance sheet                           £                   £                     £
Fixed assets (after depreciation)       100,000             127,894               100,000
Current assets (cash)                    20,000              30,000                30,000
Less creditors: due within one year           0               8,264                     0
Less creditors: due in more than one     20,000              39,091                20,000
  year (long-term debt)
Net assets (shareholders’ funds)        100,000             110,539               110,000

Gearing ratio*                               20%                 35.3%                   18.1%
  Long-term debt/shareholders’
Lease charge to profit and loss             N/A                9,461                 10,000
  for 2000
Overall profit for 2000                                       10,539                 10,000
Return on total assets†                                           6.6%                   7.6%

Notes: *The gearing ratio is the ratio of long-term debt to shareholders’ funds.
       †Return on total assets is the ratio of profits to total assets invested in the company.

balance sheet at 31st December, 2000                   operating lease under SSAP 21. If we
would be as shown in column 2 of Table                 consider column 3 of Table 4, this is the
4. During 2000, A Ltd pays £10,000 cash                reported result of the lease as if it was
to B Ltd and charges the profit and                     accounted for as an operating lease. It can
loss account with the finance charge and                be clearly seen that the overall gearing of A
depreciation for the year. From column 2,              Ltd now declines to 18.1 per cent. Effec-
it can be seen that the finance lease                   tively, the lease is now ‘off balance sheet’
increases both the assets and liabilities of           and the company is disguising the risks and
A Ltd at the end of the first year.15 If we             rewards associated with the leased asset
include the trading income of £20,000                  from the users of accounts.
cash, we can see that the cash increases by               In addition to the gearing distortions,
£10,000 (£20,000 income less lease pay-                the choice of lease accounting treatment
ment of £10,000), and the overall profit                can also affect the reported profitability of
is £10,539.                                            a company. If we consider the overall
   With the lease accounted for as a                   profit of A Ltd in the above example, it
finance lease, the company has a greatly                is clear that both the returns on total assets
increased gearing ratio of 35.3 per cent               and the overall profitability of the firm
from the existing 20 per cent. If the firm              can be creatively distorted in the early
enters into further leases, we can clearly             years of a lease. For A Ltd, the return on
see that the reported gearing level might              investment during the year 2000 is in-
hamper its future ability to borrow.                   creased by 1 per cent just by accounting
   Let us now suppose that A Ltd could                 for the lease as an operating rather than a
somehow restructure the clauses of the                 finance lease. Clearly, this could have a
lease to fit in with the definitions of an               major impact on the perceived attractive-

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Accounting for leasehold property in the UK

                             ness of the firm to new and existing           21 has not been revised since 1984, and
                             investors.                                    was only supplemented by FRS 5 in
                                Although the above example produced        1994. The ASB has long believed that
                             substantial differences in reported ac-       some reform of lease accounting is needed
                             counting performance, it must be remem-       and has been involved in the preparation
                             bered that the total payments payable over    of two radical discussion papers on the
                             the life of the lease will be exactly the     subject.
                             same, regardless of the accounting treat-        In recognition of the apparent
                             ment adopted. The distinction in ac-          deficiencies in international lease account-
                             counting treatment between operating          ing, a G4 1 Special Report on lease
                             and finance leases simply causes short-        accounting, ‘Accounting for Leases: A
                             term differences in reported performance.     New Approach-Recognition by Lessees
                             However, for a property user with a large     of Assets and Liabilities Arising under
                             portfolio of continuing and newly leased      Lease Contracts’, was published in 1996.
                             property such differences may be ex-          The paper proposed that the present
                             tremely important.16                          distinction between finance leases and
                                To summarise, reporting a lease as a       operating leases should be replaced with a
                             finance lease rather than an operating lease   single method of accounting that applies
                             has important implications for the level      to all leases. This change was justified by
                             of gearing and corporate indebtedness         claims that the comparability (and hence
                             reported in the accounts. Seen in isola-      usefulness) of financial statements would
                             tion this may not appear important, but       be enhanced if the differing treatments of
                             it could seriously hinder the strategic       operating leases and finance leases were
                             and operational ability of certain types of   replaced by an approach that applied the
                             property users. Such concerns may well        same requirements for all leases. Under
                             grow if the ASB’s proposed reforms of         the proposals put forward, all leases would
                             lease accounting come into force, as ex-      have to be fully capitalised on the balance
                             plained in the following section.             sheet, as they all give rise to material assets
                                                                           and liabilities.
                                                                              The ASB in 1999 published a discus-
                             RADICAL PROPOSALS FOR LEASE                   sion paper, ‘Leases: Implementation of
                             ACCOUNTING                                    A New Approach’, developed from the
                             The main problem faced by the ASB is          1996 G4+1 report and suggesting the
                             that, as explained in the introduction, the   same basic reforms to lease accounting,
                             leasing market is facing constant change in   whereby all leases should be capitalised on
                             the light of client demands. The leases       the balance sheet.18 The paper adopts a
                             that property companies are designing and     ‘financial components’ approach, whereby
                             signing are continually evolving and          the mere minimum legal rights and com-
                             becoming ever more complex. The ASB           mitted obligations under a lease should be
                             needs to consider how the account-            shown on the balance sheet alongside
                             ing definitions and rules on leases can        the legal rights acquired. Accordingly,
                             keep up with the changes in the               lease transactions should be considered by
                             leases. As with all accounting issues, the    reference to their legal form, in direct
                             ASB remains strongly committed towards        opposition to the current rules contained
                             providing accounting standards that en-       in FRS 5, which stresses the substance of
                             hance transparency and improve com-           the transaction over the mere legal form.
                             parability of financial statements.17 SSAP        Currently a proposal under discussion,

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                                                                                              Holt and Eccles

the ASB has now completed the consulta-        forcing up the gearing levels of the firm
tion process seeking responses from all        still further.
interested parties.19 The proposed changes        In an effort to illustrate this potential
to UK lease accounting are of potentially      impact, Beattie, Edwards and Goodacre
vital significance to property professionals    found in their 1998 survey of operating
and property users alike. If implemented,      lease use by 300 listed UK companies
the proposals could certainly force more       that, on average, the unrecorded long-
leases back ‘on’ to the balance sheet,         term lease liability represented 39 per
thereby affecting the reported perfor-         cent of reported debt, while the un-
mance of companies with substantial            recorded asset was 6 per cent of total
holdings of leased assets. This is something   assets. Capitalisation of such operating
that must be recognised and appreciated        leases was found to have a significant
by the property profession and property        impact on the profit margin, return on
users; it once again raises the spectre of     assets and gearing of each company:
the ‘economic consequences’ of account-
ing on property issues.20                        ‘The potential economic consequences
                                                 of a change in lease accounting regula-
                                                 tion are extensive. Prior empirical
PERFORMANCE IMPLICATIONS OF                      studies indicate that a wide variety
LEASE ACCOUNTING REFORM                          of individual users’ decisions, market
Under the proposed lease accounting              valuations, company cash-flows, and
changes issued by the ASB, all leases            managers’ behaviour may well be all
would be accounted for as finance leases.         affected by such a change’.21
Such a change would affect not only the
balance sheet but also the profit and loss      Despite the potential impact on reported
account. Accounting for former operat-         performance, the new lease accounting
ing leases in the same manner as finance        rules are not without their problems, and
leases completely changes the way that         these may grant an entity the ability to
lease expenses are reported in the profit       reduce the impact they make on reported
and loss account. In such cases, yearly        performance. It is to these problems that
lease expenses will no longer form a           the paper will now turn.
constant charge (which usually matches
the rentals payable) but a declin-
ing amount representing depreciation           NO PANACEA: NEW ACCOUNTING —
coupled with a finance charge on an             NEW PROBLEMS
amortising loan. In addition, the balance      It is clear that the new rules potentially
sheet will now include greater new             have immense consequences on the per-
liabilities that represent the unavoidable     formance reported in the annual accounts
legal obligations under the lease. Ob-         of certain entities. However, a number
viously, the impact of the proposed            of potential problems with the proposed
changes will be similar to the example         rules must be recognised. Primary among
produced earlier in Table 4. Lessee            these is the ability of the leasing industry
companies with large numbers of operat-        to change the nature and characteristics of
ing leases will obviously be most affected     a lease. This has happened before, fuelled
by the proposed changes. The accounting        by a constant desire to circumvent the
liabilities reported on the balance sheet      accounting rules and
will be substantially greater, thereby         fairly remove lease liabilities from the

                                                                                                    Page 243
Accounting for leasehold property in the UK

                             balance sheet. Paterson (2000)22 is very      into force as an actual accounting stan-
                             doubtful that the ASB’s new rules will        dard.
                             result in any more lease debt being              The most obvious source for creative
                             brought back onto the balance sheet:          circumvention of the ASB’s proposed new
                                                                           rules on lease accounting would be
                                ‘A leasing industry that has nimbly        through the accounting rules governing
                                skipped around the existing standard       the actual recognition and definition of
                                [SSAP 21] would not take long to           liabilities. This can best be explained by
                                relearn the rules of the game and          looking at how the proposals of the
                                develop new products to suit new           discussion paper fit alongside those cur-
                                circumstances.’                            rently contained in FRS 5. As they are
                                                                           currently written, the ASB’s lease ac-
                             It is also clear from the earlier intro-      counting proposals are inconsistent with
                             duction that property users are already       those of FRS 5 and could lead to its
                             moving towards shorter leases for com-        subsequent abolition. As outlined earlier
                             mercial reasons, and it may not be they       in the paper, FRS 5 includes rules that
                             who bear the burden of the new reporting      govern the recognition of assets and
                             requirements. While the rules on leas-        liabilities in the accounts, seeking to
                             ing may be ‘tightened up’, the lack of        report the actual commercial substance of
                             an agreed conceptual framework in UK          transactions rather than their mere legal
                             accounting23 may still allow leases to be     form. In contrast to FRS 5, the ASB lease
                             excluded from the published accounts. As      proposals within the 1999 discussion
                             was discussed earlier in this paper, lease    paper will report the strict legal rights and
                             accounting may well have its own specific      obligations under a lease transaction,
                             standard, but it is not totally self-con-     rather than the actual commercial sub-
                             tained. The current SSAP 21 and the           stance. Immediately, one can see the
                             proposed new standard are partly derived      apparent conflict between the two ap-
                             from, conflict with and are reliant on         proaches. If the ASB lease proposals
                             elements and concepts contained in other      contained within the discussion paper are
                             standards, such as FRS 5. In the ab-          actually incorporated into a new leasing
                             sence of anything approaching a unified        standard, the current FRS 5 would have
                             conceptual framework for UK account-          to be either abolished or revised to bring
                             ing, conflicts and loopholes between, and      it into line with the ‘financial com-
                             within, standards may allow the pos-          ponents’ methodology used by the discus-
                             sibility of creative accounting. Unfor-       sion paper. While this may not appear
                             tunately, there is little the ASB can do      problematic, FRS 5 has been the chief —
                             about this situation except to revise and     and most successful — weapon of the
                             issue future accounting standards using a     ASB in combating many different forms
                             more unified and integrated approach.          of ‘off balance sheet’ financing that used
                             Accounting abuses in other areas have         to be prevalent in UK accounting
                             effectively limited the ability of the ASB    practice. Lease accounting is just one area
                             to draft ‘watertight’ new proposals on        where ‘off balance sheet financing’ is a
                             lease accounting. Such concerns and their     major issue. The abolition of FRS 5 in
                             solution are obviously beyond the remit       favour of a ‘financial components’ lease
                             of this current paper, but suggest that the   model might well allow ‘off balance sheet’
                             proposals for lease accounting reform may     financing to become prevalent once again
                             take another direction before they come       in all areas of accounting, not just in

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                                                                                                Holt and Eccles

lease accounting. Thus, the ASB’s lease         likely to happen, such clauses will effec-
reforms might not actually result in the        tively limit the lessee’s unavoidable legal
capitalisation of all the obligations under     obligations under the lease to a small
leases, especially in the longer term           amount at any one time. As a defence
when creative accountants and property          against this, the original G4+1 paper and
managers devise lease clauses in a manner       the ASB discussion paper both suggest
that reduces the legal obligations or           that where the entity was ‘compelled’ by
commitments of a lease.                         practical considerations to keep an asset
   The above problem is best explained          beyond the minimum contracted term, it
through the use of a simple example.            should account for the rentals payable
Suppose, for example, a lessee enters into      over that longer period. However, this
a 10-year lease on a building at £1m a          defence has problems in defining exactly
year, with the fair value of the building       what ‘compelled’ actually means in prac-
being £10m. The terms of the lease allow        tice. Any decision is arbitrary.
the lessee to cancel it at any time, but if        In essence, then, the ASB proposals on
cancelled then the lessee must sell the         lease accounting reform may be rendered
asset, retaining any profit or loss on dis-      impotent by new forms of lease agree-
posal. Under FRS 5, the lease would be          ment that contain complex clauses in a
capitalised ‘on balance sheet’, as the risks    bid to circumvent them. Once again, a
and rewards of ownership had effectively        battle between the rules introduced by the
passed to the lessee. Under the proposals       ASB and the creativity of the individuals
of the ASB discussion paper, this lease         drawing up lease agreements will deter-
would be entirely off balance sheet, as         mine the practical results of the changes.
there was no committed lease outflow and         In addition, as was discussed at the
the sale transaction would have not taken       commencement of the paper, regardless of
place. The minimum lease payment on             accounting proposals, changes in business
applying the discussion paper would be          practice concerning shortening of leases
one year, which would result in a fun-          might negate the entire premise behind
damental change away from the principles        the rule changes. On the other hand, at
of FRS 5. Thus the proposals in the             times when the landlord is in the
discussion paper would lead to transac-         ascendant, it might be argued that
tions being considered only by reference        accounting pressures are less immediate to
to their legal form and could result in a       lessees, who will find themselves in a
whole new industry of ‘off balance sheet        weaker position to negotiate their re-
financing’.                                      quirements within a lease agreement. In
   So although the proposals of the ASB         any event, the proposed accounting
discussion paper aim to get all leases          changes will reflect upon commercial
capitalised in the balance sheets of lessees,   practice.
they may eventually fail to do so. The use         Of course, until the new standard is
of a ‘financial components’ approach to          published it is unclear what it will actually
capitalisation may lead directly to the         mean for property companies holding
development of new types of leases that         large portfolios of leased assets. For
include frequent break clauses in an effort     such companies, especially those holding
to evade the proposals to include all leased    operating leases, it is likely to prove
assets and liabilities on the balance sheet.    financially beneficial in terms of their
Although the terms on which such lease          reporting requirements to shift their
clauses may be exercised are highly un-         property portfolios into certain types of

                                                                                                      Page 245
Accounting for leasehold property in the UK

                             lease agreements that offer a short-term         ultimately take. What is clear is that
                             positive influence on their accounting            property users, owners, professionals and
                             performance. This suggests that the new          valuers have a more pragmatic inter-
                             financial reporting standards will lead to        est in this issue than do accountants
                             strong pressure for leasehold tenants to         seeking to rationalise their intellectual
                             demand either short leases or short-term         framework in isolation. In addition, those
                             break clauses in long leases. In addition to     developments outlined in the introduc-
                             changing commercial practice in many             tion as simple commercial decisions will
                             regions, this suggests that that the long-       clearly now have additional motivation
                             term lease is unlikely to survive, unless        from the onerous lease accounting being
                             lessees are willing to accept heavy report-      proposed. Lessees must obviously seek to
                             ing penalties. This, in turn, suggests           minimise their financial reporting obliga-
                             that the entire process of property              tions through careful construction of their
                             development and lease negotiation must           leases and insistence on shorter terms and
                             reflect these changes. Financial reporting        break clauses. This is no longer a reflec-
                             liabilities for leases will become in            tion of changing business practice, but a
                             themselves a charge that must be paid for        necessary part of the reporting function.
                             and be reflected in the development               In turn, this will force developers to
                             process. Finally, and just as importantly,       re-appraise their own decisions in offering
                             the potential abolition of FRS 5 under the       properties for lease. Shorter leases will also
                             ASB’s lease reforms may well have similar        lead to more expiries and to associated
                             consequences for the structuring, recogni-       dilapidations claims and disputes affecting
                             tion and reporting of other types of             building surveyors and general practice
                             liabilities within UK accounts and may           surveyors. It is clearly not the purpose of
                             thereby open up a whole episode of ‘off          this paper to develop these issues, and it
                             balance sheet financing’.                         is not feasible to do so until the new
                                                                              regulations are drafted, but all those in-
                                                                              volved with leased property need to pre-
                             Conclusion                                       pare for change.25
                             It is likely that the result of these develop-
                             ments will be that leases become much            REFERENCES
                             more complicated, as additional clauses           (1) Holt, A. and Eccles, T. (2001)
                             are introduced to circumvent any ac-                  ‘Accounting for Property in the UK:
                             counting standard that relies on condi-               The Legal and Professional Framework’,
                             tional rules. As Paterson (2000) points out           Journal of Corporate Real Estate, Vol. 3,
                             inter alia24 this may be to the detriment of          No. 2, pp. 132–149.
                             the lessees, investors and property profes-       (2) Published by International Thomson
                             sionals. ‘Substance over form’ has been a             Business Press.
                             rallying cry for UK standard setters for a        (3) Both published by International
                             long period of time. In the battle over               Thomson Business Press.
                                                                               (4) Crosby, N. and Murdoch, S. (1998)
                             lease accounting this continues to be a
                                                                                   ‘Changing Lease Structures in
                             tough term to bring to bear. Now that the             Commercial Property Markets’, Royal
                             ASB proposals have been published and                 Institution of Chartered Surveyors
                             the consultation period has been com-                 (RICS), London; Crosby, N. et al.
                             pleted, only time — and perhaps further               (1998) ‘Market Views on Changing
                             consultation — will show the form which               Business Practice, Leases and Valuation’,
                             the ASB revisions to lease accounting will            RICS, London.

Page 246
                                                                                                    Holt and Eccles

(5) See for example Coppin, L. (2000)                   ASB, London; ASB (1994), ‘FRS 5:
    ‘Lease Rebellion on Cards’, Estates                 Reporting the Substance of
    Gazette, 17 June, p. 62; Crosby, N. et              Transactions’, ASB, London; ASB
    al. (2000) ‘Monitoring the Code of                  (1999) ‘Leases: Implementation of a
    Practice for Commercial Leases’,                    New Approach’, ASB, London; ASB
    DETR, London; Crosby, N. and                        (2000) ‘Responses to Discussion Paper
    Murdoch, S. (2000) ‘Decoding Lease                  ‘‘Leases: Implementation of a New
    Structures’, Estates Gazette, 20 May, pp.           Approach’’ ’, ASB, London.
    153–156; Maguire, J. (1998) ‘Work            (10)   These calculations are beyond the scope
    Grows as Leases Sink’, Property Week,               of this paper, but are contained within
    23 January, p. 32; Rose, A. (2000)                  the appendix to SSAP 21.
    ‘Retailers Prepare Fight for Flexibility’,   (11)   ASB (1994), see ref. 9 above, at p. 427.
    Estates Gazette, 17 June, p. 61.             (12)   ASB (1994) (ref. 9 above) at para. 45.
(6) See for example Bradshaw, M. (2000)          (13)   ASB (1994) (ref. 9 above) at para. 57.
    ‘Selling Upward-only Ban to Labour’,         (14)   ASB (1994) (ref. 9 above) at para. 56.
    Property Week, 1 September, p. 22;           (15)   The actual amounts for these were
    Ellison, W. (2000) ‘The Long and Short              shown in Table 4.
    of It’, Estates Gazette, 14 October, pp.     (16)   As mentioned previously, this is also
    107–108; Harrold, R. (1993) ‘The Cost               mirrored within the accounts of the
    of Prohibiting Upward-only Rent                     company owning the properties.
    Reviews’, Estates Gazette, 20                (17)   An issue developed within our previous
    November, p. 169; Raynsford, N.                     paper; see ref. 1 above.
    (2000) Letter to the editor, Property        (18)   For ASB (1999) see ref. 9 above.
    Week, 3 November, p. 27; Roberts, J.         (19)   ASB (2000); see ref. 9 above.
    (2000) ‘Onwards is Still Only Upwards        (20)   A further issue developed in our earlier
    in Lease Talks’, Estates Gazette, 9                 paper (ref. 1 above).
    September, p. 35; Smith, K. (2000)           (21)   Beattie, V., Edwards, K. and Goodacre,
    ‘Raynsford on the Rampage’, Property                A. (1998) ‘The Impact of Constructive
    Week, 1 September, pp. 10–11; Welsh,                Operating Lease Capitalisation on Key
    J. (2000) ‘Rents Can Go Down as Well                Accounting Ratios’, Accounting and
    as Up’, Property Week, 3 November, p.               Business Research, Vol. 28, No. 4, pp.
    25.                                                 233–254; quotation at p. 253.
(7) This is obviously contingent upon the        (22)   Paterson, R. (2000) ‘A New Lease of
    standard being completed. The initial               Strife’, Accountancy, December, p. 93.
    discussion paper prior to the                (23)   Our earlier paper (ref. 1 above) offers a
    consultation process has only just been             detailed description of the problems this
    completed. The standards within this                causes for UK accounting in general
    paper remain valid until the adoption               and property in particular.
    of the new standard.                         (24)   See ref. 22 above.
(8) See ref. 1 above.                            (25)   The exact nature of the new proposals
(9) The following are full references to all            and a detailed discussion of the
    standards referred to within this paper:            arguments advanced in response to the
    ASB (1984), ‘SSAP 21: Accounting for                initial discussion paper are beyond the
    Leases and Hire Purchase Contracts’,                scope of this paper.

                                                                                                          Page 247

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