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From this article you will learn:
- How to determine the value of leasing liability?
- How to account for the initial fee paid at the conclusion of the contract?
- How to find the information about the interest rate of the lease?
Junior Audit Manager at RSM Poland
In our articles about leasing, we have already written about the classification of leases on the balance sheet and the economic life of leased assets according to balance sheet law. On a few examples we have shown how to interpret the regulations in this area in order to have the most reasonable estimation. In this post, we will take a look at discounting cash flow related to the lease agreement and the relation between that cash flow and the market value of the lease object.
Future value of lease agreement – what are the balance law regulations?
The balance law regulations regarding leasing indicate:
If the amount of leasing charges, reduced by discount, that is determined on the initiation of a contract and has to be paid during the period of the contract, surpass the limit of 90% of the leased asset’s value on the day of the initiation of the contract, we are dealing with the financial lease on the balance sheet.
Just one sentence of the norm, but it, can raise many questions:
- Should the amount of leasing charges contain the initial and the final fee?
- Should we include additional services (e.g. car fleet management) and service fees?
- How to asses the discount rate at the time of the rapid decline of the value of money over time?
The amount of leasing charges is the value of the whole liability, resulting from the conclusion of the lease contract, which will be payable within the duration of the agreement.
The value of the leasing agreement consists of a couple of elements
One of the component parts is monthly leasing payments. The amount of the monthly lease charge results directly from the contractual schedule, and it is definitely the most important element in „the amount of leasing charges” mentioned in the balance law, which we are trying to define here.
The initial and the final fee can prove somewhat more problematic. The National Accounting Standards 5 „Leasing, rental and leasehold” in par. 4.2.4 precisely point that the final fee is included in the amount discounted. However, in the case of the initial fee there isn’t any clear information. Therefore, doubts may arise.
What is the initial fee and how a lessee should account for it?
Basically, the initial fee is paid at the beginning of the contract. The doctrinal approach to accountancy tells us to, first of all, record this fee in the accounting records and then settle it. In practice, the entrepreneurs opt for a certain simplification and record the value of the leased asset and the financial liability without including the initial fee.
What do the National Accounting Standards 5 say about the initial fee?
To find the answer, it is necessary to familiarise oneself with the definitions adopted for the purposes of this standard. Pt 3.17. shows that the lease charges are generally paid during the period of leasing. A lessee is or can be obliged to pay them.
In the case of a lessee, the amount of charges should also include the final fees. Looking for a mention of the initial fee in the National Accounting Standards 5, however, is pointless, which in combination with the business practice and the aforementioned simplification in record allows to say that the initial fee isn’t an element of the amount of charges that should be discounted.
The costs of servicing, tyre change, fleet management… Can additional fees be discounted?
The initial and final fees aren’t everything, during the leasing there are more expenses. What should be done about them? It may seem that the regulations don’t leave the space for a loose interpretation, after all The National Accounting Standards 5 in the guidelines say:
Contingent fee (the fees the value of which is not fixed and depends on future factors – ed.) doesn’t include the lease charges or the payment for the additional services to a funder, taxes and insurance contributions if the user covers them regardless of the usage charge.
There comes the problem. How to determine the independence of the additional fees from the fees related to the usage of the leased asset? It’s not always intuitive, especially when a lessor provides an invoice where one item includes all of the fees and the conditions of the lease contract don’t clearly indicate the inseparability of the services.
Another problem related to the additional fees is the matter of the lessee’s potential benefits. If a lessee benefits from the services related to using the leased asset, the value of the charges should be included in the amount of leasing charges which will be discounted.
Specifying the benefits mentioned is very subjective, and the standard doesn’t say what criteria a taxpayer should follow. RSM Poland auditors, experiences’ regarding this matter are so extensive, that we can point a way to interpret this part of the regulations with full confidence. Let's look at an example.
- Agreement to lease curtain trailers concluded for the period of 48 months.
- Additional service: tyre change every 3 000 km, with the limit of a maximum of 16 tyres during the whole period of the lease agreement.
When the tyre change within the lease contract brings profits? When the lessee doesn’t organise the change on their own and doesn’t incur the additional charges related to purchasing the tyres. Material benefits are more intuitive, however, the non-material ones, e.g., the time saved, should also be considered.
Discounting the amount of lease charges in times of inflation
Discounting should illustrate the current value of the contract with consideration of the devaluation of money in time. The value of the lease contract determined in this way is a starting point to assess if the limit of 90% of the leased asset’s value will be surpassed (and thus, to assess if the lease contract will be classified as the financial lease on the balance sheet).
At the same time, discounting brings recent months biggest problems on our analysis, which are raging inflation, time devaluation of money and therefore rising interest rate that affects the costs of external financing.
The regulations point that, in order to discount the amount of lease charges, the interest rate in the lease valid on the day of the conclusion of the contract should be applied. The National Accounting Standards 5 suggest using the indicators specified in the agreement at the stage of discounting. Some of the lessors specify the interest rate in the lease in the contract terms precisely. It’s not a rule though.
What if in the lease contract there is no information about the interest rate?
In the guidelines for pt. 4.2.4. of the standard, the legislator as an alternative gives the interest rate valid on the day of the lease contract conclusion. It is the interest rate which a lessee would have to pay from a similar leasing contract. In the case of financing with a larger scale, it is worth looking at the conditions of an already concluded agreement on a similar leased asset. If we don’t have such a possibility (or the data obtained in this way aren’t comparable), the final solution is to use the interest rate of the other source of funding (credit or loan with similar collateral), which a lessee could obtain for a similar purpose and period.
Discounting a lease requires solid preparations, but it’s not necessarily difficult
We hope we once again managed to prove that the classification of leases is not as complicated as the complex language of the Polish law suggests.
Nevertheless, every contract requires a broader look. A safe approach demands developing schemes of procedures in the case of individual contracts, schemes that can be easily copied in the future. In the case of doubts regarding the classification of contracts, contact us and follow our blog, there are a lot of interesting audit topics ahead.