Finance Leasing Manual - FLM4.01

Accountancy treatment of finance leases before 1984

The accountancy treatment of leasing is important because the tax treatment depends in part on correct accountancy.

Until 1984 accountants usually followed the legal form in dealing with finance leases in accounts. This meant:

Finance lessor's accounts

• The lessor showed the kit it leased out in its balance sheet as its own capital asset. The capital cost of the asset was written off as 'depreciation' to the profit and loss account over the primary period of the lease as the 'loan' was repaid. The primary period is the period over which the loan is repaid.

• The lessor showed the gross rents receivable ('loan capital' plus 'interest') as its trading receipts. In addition, depreciation on the asset was deducted in its profit and loss account. The total depreciation charge over the primary period equalled the 'loan capital' element in the rents. This, in turn, normally equalled the capital cost of the leased kit. The depreciation charge had nothing to do with the actual depreciation of the kit. It was just an accountancy mechanism to remove the kit from the balance sheet by the end of the primary period and leave the 'interest' earnings as the real commercial earnings.

• In effect, therefore, the 'interest' was the lessor's commercial gross earnings. From this it deducted its own interest payments (the major expense) and other administrative expenses.

Finance lessee's accounts

• The lessee showed nothing in his balance sheet - neither the asset nor the 'loan' appeared.

• The lessee showed the gross rental payments as deductions in the profit and loss account, usually over the primary period.

This treatment did not reflect the commercial and economic reality of a finance lease. Finance leasing became attractive in part because it was 'off balance sheet' for the lessee. The lessee could conceal the fact that it was considerably in debt. Numerous problems developed and there were major crashes which became scandals.