It is normal for businesses to acquire assets through hire purchase and leasing and in
many cases the benefits of ownership pass in substance to the entity acquiring and
using the asset even though ownership itself does not pass in true legal form. SSAP 21
covers the accounting treatment necessary for the correct disclosure of these contracts
in order that the transaction is reported fairly in the financial statements without
misleading effects on the gearing ratio.
Under a hire purchase contract ownership does not pass until the final instalment has
been paid if the option to purchase is exercised. However the accounting treatment for
such contracts requires that the asset be capitalised at the outset at its cost and that the
interest payments be put through the profit and loss account as they are paid – being a
cost of finance.
A credit sale agreement is one whereby payment for goods is spread over five or more
instalments. Ownership passes on delivery of the goods to the buyer. Credit
instalments are paid and the accounting treatment is the same as that for goods
acquired under a hire purchase agreement.
Under a lease agreement goods are hired for a fixed minimum period with rights of
renewal. The goods remain the property of the hirer.
A finance lease is one in which the rights and responsibilities of ownership of the asset
pass to the lessee. The substance of such a lease is the same as an asset acquired
a hire purchase agreement. There are certain features which indicate whether a lease
falls into this category. The two main ones are:
• The ‘90% test’ – if at the beginning of the lease the present value of the minimum
lease payments amounts to substantially all (90% or more) of the fair value of the
leased asset. This test is performed in the following way:
• Discount MLP to the present value
• Calculate the minimum lease payment (MLP)
• Estimate the fair value of the asset i.e. the value at which the asset could be
acquired in an arm’s length transaction
• Compare the fair value with the discounted MLP
• That all the risks and rewards of ownership pass to the lessee
SSAP 21 states that the even if the 90% test applies a lease should not be treated as a
finance lease if the risks and rewards of ownership have not passed to the lessee. Also
if it fails the 90% test but the risks and rewards have passed then it should be treated as
a finance lease. However, this should only be done in ‘exceptional circumstances’
which can cause interpretation problems.
Essentially a lease is a finance lease if:
• The lessee may use the asset for its economic life
• The lessee is responsible for repairing and insuring the asset
• The asset is a specialist item so that only the lessee can use it
• There is an option of a secondary lease term at a nominal rent.
At the outset of the lease an amount equivalent to the fair value of the leased asset
should be capitalised – i.e. the capital cost. The credit entry is to the obligation under
finance lease account. The asset should be depreciated over the shorter of:
• The useful economic life
• The lease term
The finance charge is the difference between the fair value of the asset and the total
amount to be repaid. This is charged to the profit and loss account over the period of
the lease. The difficulty arises with how to apportion the finance charge between the
relevant periods. There are three main methods of apportionment:
• Actuarial method
The implied rate in the lease is used, the charge for each period being calculated
according to the capital outstanding.
• Sum of the digits method
This is an approximation of the above method and should only be used when the
implied rate is not available.
• Straight line method
This involves apportioning the charge equally over the period of the lease. It is
not very accurate, and should only be used when the amounts involved are
The finance charge should be debited to the profit and loss account and credited to the
obligations under finance lease account to increase the liability. On payment of an
instalment the obligations under finance lease is debited to reduce the liability and
cash will be credited.
The amount included in the deprecation charge in the profit and loss account which
relates to assets held under finance leases must be disclosed separately in the operating
profit note. The finance charge must be disclosed separately in the interest payable
and similar charges note.
In the fixed assets note the net book value of assets held under finance leases should be
shown separately. The creditors notes must also specify the amounts outstanding
under finance leases and in addition the following sub-divisions:
Amount falling due within one year X
2-5 years X
After 5 years X
Less: future finance charges (X)
Alternatively the above break-down may be shown net without the separate figure for
future finance charges.
Winthrop Ltd leases an asset which has a useful economic life of 5 years. It is
responsible for maintenance of the asset. The item could be purchased for £33,000.
The implied rate of interest in the lease is 10%. The annual rentals, which span its
useful economic life, are £7,500.
Is this a finance lease?
Any lease which does not fall into the category of a finance lease is an operating lease.
The accounting treatment of an operating lease is straightforward – rentals are charged
to the profit and loss account on a straight-line basis over the period of the lease.
In the operating profit note the amount charged as operating lease rentals must be
specified and broken down into that relating to the hire of plant and machinery and
that relating to the hire of other items.
A note must be made of commitments under operating leases. This does not relate to
any figure in the accounts but rather gives information about future liabilities. The
amounts must be broken down into commitments for land and buildings and those for
items. The timing of such payments must be specified – within one year, 2-5 years and
after 5 years.
Winthrop Ltd leases another asset which would cost £20,000 on the open market. They
will pay a deposit of £1,150 and then seven annual instalments of £4,000 at the end of
each year.
Calculate the interest charge for each year using
• the actuarial method (the implicit rate of interest is 11% pa)
• the sum of the digits method
• the straight-line method.

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