BIM61150 - Leasing: Finance lessees: rentals written off over short primary period

A point similar to that described in BIM61145 may also arise where, as is usually the case, a lease does provide for a secondary period but:

• the primary period is significantly shorter than the likely useful life of the asset; and
• the accounting treatment, said to be consistent with SSAP 21, is to depreciate fully the leased asset over the primary period or, indeed, on any basis which uncommercially accelerates the rate of relief.

Accountancy considerations

Under SSAP 21 a leased asset is depreciated over the shorter of its expected useful life and the term of the lease. The term of the lease should include secondary periods where it is `reasonably certain' that the lessee will not terminate beforehand. In an arm's length deal, no lessee is going to pay out the full the cost of buying the asset, plus interest, without either securing the right to use the asset for as long as it lasts or without securing the right to be paid the market value of the asset when the lease ends.

Line to take

Where there are secondary periods, and the asset is expected to have significant residual value at the end of the primary period, either:

• it is `reasonably certain' at the inception of the lease that the lessee will not exercise the right to terminate it at the end of the primary period, and therefore the asset should be written off over the shorter of its useful life and the term of the lease including secondary periods; or
• if the lessee is able to show that termination at the end of the primary period is likely, the depreciation charge should reflect the value of the asset on termination (which will come back to the lessee as a rebate).

Example

Consider the following simplified example:

• an asset which has a cash cost of £30m has a life of ten years;
• a trader leases the asset over a primary period of five years in which rentals (excluding the finance charge element) of £6m a year are payable;
• the lessee has the right to continue to lease the asset for as long they like after the primary period on payment of £10 (ten pounds) a year;
• after five years the asset is half consumed and is worth £15m.

On these facts the £30m capital cost of the asset will be consumed over ten years. This produces a depreciation charge of £3m each year the asset is held, whether it is held for ten years or whether it is going to be sold when the primary period ends:

• if the asset is kept for its ten year life, there will simply be depreciation charges of £3m a year for ten years.
• if the asset is sold after five years, the residual value at the five year point will be £15m and so the net amount to be written off is £15m (£30m less £15m). This is £3m a year for five years.