FRS 17: Finance Leases – Understanding the Accounting Standard

FRS 17, now superseded by IFRS 16, outlined the accounting treatment for leases, distinguishing between operating leases and finance leases. Understanding FRS 17’s principles regarding finance leases remains valuable for interpreting historical financial statements prepared under that standard and for grasping the foundational concepts behind lease accounting. A finance lease, under FRS 17, was essentially a lease that transferred substantially all the risks and rewards incidental to ownership of an asset to the lessee. This meant the lessee enjoyed the economic benefits of the asset’s use while also bearing the risks of obsolescence or diminished value. The determination of whether a lease was a finance lease involved assessing several indicators. While no single indicator was definitive, the presence of one or more often signaled a finance lease. These indicators included: * **Transfer of Ownership:** The lease transferred ownership of the asset to the lessee by the end of the lease term. This was a strong indication of a finance lease, as the lessee would ultimately own the asset. * **Bargain Purchase Option:** The lessee had the option to purchase the asset at a price significantly lower than its fair value at the date the option became exercisable. This option implied the lessee was effectively pre-paying for the asset. * **Lease Term Substantially Covering Asset’s Life:** The lease term was for the major part of the asset’s economic life. This indicated the lessee was deriving the primary economic benefit from the asset over its useful life. * **Present Value of Lease Payments Approximating Fair Value:** The present value of the minimum lease payments (excluding contingent rent) at the inception of the lease substantially equated to the asset’s fair value. This implied the lessee was effectively financing the purchase of the asset. * **Specialized Asset:** The leased asset was of such a specialized nature that only the lessee could use it without major modifications. If a lease was classified as a finance lease, both the lessee and the lessor had to account for it differently than an operating lease. **Lessee Accounting:** The lessee recognized the leased asset and a corresponding lease liability on its balance sheet at the lower of the asset’s fair value and the present value of the minimum lease payments at the inception of the lease. The asset was depreciated over its useful life or the lease term, whichever was shorter. The lease payments were split into a reduction of the lease liability and an interest expense, which was recognized in the profit or loss. **Lessor Accounting:** The lessor derecognized the asset from its balance sheet and recognized a finance lease receivable at an amount equal to the net investment in the lease. The net investment was the gross investment (minimum lease payments plus any unguaranteed residual value) discounted at the interest rate implicit in the lease. The lessor recognized finance income over the lease term to reflect a constant periodic rate of return on the lessor’s net investment. In conclusion, FRS 17’s treatment of finance leases aimed to accurately reflect the economic reality of transactions where the risks and rewards of ownership were transferred to the lessee, ensuring a more transparent and informative presentation of financial position and performance. Understanding these principles is key when reviewing financial statements prepared under FRS 17.