Download UITF abstract 28 Operating lease incentives

UITF Abstract 28.qxd 21/02/01 12:26 Page 21
ABSTRACT 28
UITF abstract 28
Operating lease incentives
(Issued 22 February 2001)
The issue
In negotiating a new or renewed operating lease, a lessor may provide incentives for the
lessee to enter into the agreement. Examples of such incentives are an up-front cash
payment to the lessee or the reimbursement or assumption by the lessor of costs of the
lessee (such as relocation costs, and costs associated with a pre-existing lease commitment
of the lessee). Alternatively, initial periods of the lease term may be agreed to be rent-free
or at a reduced rent.
1
The issue is how an incentive for an operating lease should be recognised in the financial
statements of the lessee and of the lessor.
2
A payment (or other transfer of value) from a lessor to (or for the benefit of) a lessee
should be regarded as a lease incentive when that fairly reflects its substance. A payment
to reimburse a lessee for fitting-out costs should be regarded as a lease incentive where
the fittings are suitable only for the lessee and accordingly do not add to the value of the
property to the lessor. On the other hand, insofar as a reimbursement of expenditure
enhances a property generally and causes commensurate benefit to flow to the lessor, it
should be treated as reimbursement of expenditure on the property. For example, where
the lifts in a building are to be renewed and a lease has only five years to run, a payment
made by the lessor may not be an inducement to enter into a lease but payment for an
improvement to the lessor’s property.
3
This Abstract does not deal with incentives to surrender leases. However, such incentives
should be examined to determine whether in substance the incentive relates to the new
lease, particularly where the offer of the incentive is linked to an arrangement to vacate a
property under lease from a different lessor. Such consideration should take into account
the market rentals applicable to the old and new leases. If it is determined that the
incentive, or part of it, relates in substance to the new lease, the provisions of this Abstract
apply.
4
SSAP 21 ‘Accounting for leases and hire purchase contracts’ does not deal specifically
with accounting for lease incentives. However, it requires lessees to charge operating
lease rentals “on a straight-line basis over the lease term, even if the payments are not
made on such a basis, unless another systematic and rational basis is more appropriate.”
(paragraph 37)
5
As regards lessors, SSAP 21 requires that “Rental income from an operating lease,
excluding charges for services such as insurance and maintenance, should be recognised
on a straight-line basis over the period of the lease, even if the payments are not made on
such a basis, unless another systematic and rational basis is more representative of the
time pattern in which the benefit from the leased asset is receivable.” (paragraph 43)
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UITF CONSENSUS PRONOUNCEMENTS
7
A lease may be structured in a way that accords with the cash flow needs of the lessee, for
example by providing for rental reductions or payments from the lessor when certain costs
are incurred by the lessee. An up-front incentive creates a presumption that the
subsequent rentals are above the level acceptable to the parties in the market current at the
time (even though they may be termed ‘market rate’). This is because a lessor’s main
objective is to obtain the best rent available from the lessee for the property in question
and the lessor has no interest in how a lessee spends any up-front incentive paid.
8
In accordance with the accruals concept, any incentive should be allocated to match the
effect of the increased rentals payable in later periods, so that the financial statements
reflect the true effective rental for the premises, irrespective of the particular cash flow
arrangements agreed between the parties. The accounting treatment should be similar,
however the arrangement is structured.
9
Many leases provide for periodic reviews whereby the rental can be adjusted to the
prevailing market rate. In such a case it is necessary to recognise the incentive over the
period in which, before taking account of the incentive, the rentals will be other than the
market rate. This will generally be the period up to the first review date at which the rental
being paid is expected to come into line with the prevailing market rate. Neither
SSAP 21 nor the Guidance Notes specifically address the situation where rentals are
periodically reviewed.
10
SSAP 19 ‘Accounting for investment properties’ requires investment properties to be
reported in the balance sheet at their open market value. That value should not include
any amount that is reported as a separate asset, for example as accrued rent receivable, if
there would be double-counting of assets. For example, a property might have a value of
£20 million reflecting, in part, the rents on a lease that has been negotiated with a tenant.
However, if a lease incentive (of say £1 million) was given as part of the negotiation of
that rent, the open market value to be reported under investment properties would be
£19 million, as the other £1 million would be reported as a separate asset.
11
Where a debtor is recognised in respect of an operating lease incentive, the requirements
of UITF Abstract 4 ‘Presentation of long-term debtors in current assets’ may be relevant.
Application to smaller entities
12
Reporting entities applying the Financial Reporting Standard for Smaller Entities
currently applicable are exempt from this Abstract.
UITF consensus
13
All incentives for the agreement of a new or renewed operating lease should be recognised
as an integral part of the net payment agreed for the use of the leased asset, irrespective of
the incentive’s nature or form or the timing of payments.
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ABSTRACT 28
Accounting by lessees
A lessee should recognise the aggregate benefit of incentives as a reduction of rental
expense. The benefit should be allocated over the shorter of the lease term and a period
ending on a date from which it is expected the prevailing market rental will be payable.
The allocation should be on a straight-line basis unless another systematic basis is more
representative of the time pattern of the lessee’s benefit from the use of the leased asset.
14
Accounting by lessors
A lessor should recognise the aggregate cost of incentives as a reduction of rental income.
The cost of the incentives should be allocated over the lease term or a shorter period
ending on a date from which it is expected the prevailing market rental will be payable.
The allocation should be on a straight-line basis unless another systematic basis is more
representative of the time pattern in which the benefit from the leased asset is receivable.
15
Where a building is accounted for as an investment property, the value at which it is stated
in the balance sheet should not include any amount that is reported as a separate asset, for
example, as accrued rent receivable.
16
In accordance with normal accounting practice, an amount recognised as a debtor in
respect of an operating lease incentive should be written down to the extent that it is not
expected to be recovered.
17
Date from which effective and withdrawal of UITF Abstract 12
The accounting practices set out in this Abstract should be adopted for financial
statements relating to accounting periods ending on or after 22 September 2001 (including
corresponding amounts for the immediately preceding period) in respect of lease
agreements commencing in the current or the preceding accounting period. Adoption in
respect of earlier lease agreements is permitted but not required.
18
This Abstract supersedes UITF Abstract 12 ‘Lessee accounting for reverse premiums and
similar incentives’.*
19
References
ASB pronouncements
SSAP 19 ‘Accounting for investment properties’, paragraph 11
SSAP 21 ‘Accounting for leases and hire purchase contracts’, paragraphs 37 and 43
FRS 18 ‘Accounting Policies’, paragraphs 26 and 27
UITF Abstract 4 ‘Presentation of long-term debtors in current assets’
IASC pronouncements
Standing Interpretations Committee, SIC-15 ‘Operating Leases - Incentives’
IAS 40 ‘Investment Property’, paragraph 44
*
UITF Abstract 12 superseded that part of the guidance given in paragraph 16 of the Guidance Notes on SSAP 21 which
suggests that the total rentals should be charged “over the period in which the asset is in use”.
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UITF CONSENSUS PRONOUNCEMENTS
APPENDIX
Illustrative examples of the consensus in paragraphs 13-17
The examples each assume a lease for five years. It is assumed that a straight-line allocation
basis is the most representative of the benefits. The accounting is illustrated from the perspective
of the lessor. The lessee’s expense would be equivalent to the lessor’s income.
(a)
First year rent-free, then four annual rentals of £500
Year
(b)
£ Income
£ Cash
£ Debtor
For year
Cumulative
Movement
in year
Cumulative
Movement
in year
Cumulative
1
400
400
—
—
400
400
2
400
800
500
500
(100)
300
3
400
1,200
500
1,000
(100)
200
4
400
1,600
500
1,500
(100)
100
5
400
2,000
500
2,000
(100)
—
Cash incentive of £1,000 paid, and five rentals of £600
Year
£ Income
For year
Cumulative
1
400
400
400
800
400
1,200
400
1,600
400
2,000
2
3
4
5
£ Cash
Movement
Cumulative
in year
(1,000)
600
(400)
600
200
600
800
600
1,400
600
2,000
4
£ Debtor
Movement
Cumulative
in year
1,000
(600)
400
800
(600)
400
600
(600)
400
400
(600)
400
200
(600)
400
—
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ABSTRACT 28
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