Recognition of operating lease payments which are linked to inflation
SSAP 21 requires a lessee to recognise operating lease rentals as an expense on a straight-line basis over the lease term, unless another systematic and rational basis is more appropriate. SSAP 21 does not specifically consider how to treat rental increases intended to compensate the lessor for the impact of inflation.
FRS 102 (Section 20) specifies the accounting treatment in this scenario, requiring a lessee to recognise lease rentals on a straight-line basis over the lease term, except when
a) another systematic and rational basis is more appropriate, or
b) the payments to the lessor are structured to increase in line with expected general inflation.
Where b) applies, the lessee recognises any inflationary element as and when it is payable rather than on a straight-line basis. Any rental increase treated in this way must be based on published indexes or statistics. Escalating payments which are not clearly structured to compensate the lessor for the effects of inflation should be spread on a straight-line basis, unless another basis is more appropriate.
Example:
A Ltd leases some machinery from B Ltd for a period of five years, both entities operate in the UK. A Ltd expects to obtain the same level of benefit from the machinery each year.
Under the lease agreement, A Ltd is required to pay B Ltd rentals of £10,000 increasing by 2.5% per year. 2.5% is equal to the Bank of England’s expectation of annual inflation over the lease period.
The rentals are:
Year 1: £10,000
Year 2: £10,250
Year 3: £10,506
Year 4: £10, 769
Year 5: £11,038
Total: £52,563
Under SSAP 21, A Ltd would recognise the rentals on a straight-line basis leading to an annual expense of £10,513.
Under FRS 102, Section 20, A Ltd would recognise the rentals as stated above because the escalating payments are clearly structured to compensate the lessor for expected inflationary cost increases.
As a consequence, the adoption of FRS 102 may have an impact on profit or loss for entities with lease rentals linked to inflation, depending on how the rentals were accounted for under SSAP 21.
Operating lease incentives
A lessor may sometimes provide an incentive for the lessee to enter into a lease agreement. Examples of incentives include an up front cash payment to the lessee, reimbursement or assumption by the lessor of the costs of the lessee (such as relocation costs and costs associated with a pre-existing lease commitment of the lessee) and a rent free or reduced rent period.
Both UITF Abstract 28 and FRS 102 require the lessee to recognise the aggregate benefit of lease incentives as a reduction in rental payments. However, whereas UITF 28 requires the benefit to 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, FRS 102 requires the benefit to be allocated over the lease term. In both cases, the lease term is the non-cancellable period of the lease plus any extensions at the lessee’s option where, at inception of the lease, it is reasonably certain that the lessee will exercise the option.
There may be situations where the application of FRS 102 would lead to the lease incentive being deferred over a longer period than that under UITF 28. However, a transitional provision (FRS 102, Section 35) provides that UITF 28 and not FRS 102 can continue to apply to lease incentives relating to leases that commenced before the date of transition.
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