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From this article, you will learn:
- What regulations help determine if it is a finance lease or not?
- What should be considered when determining the economic life of the lease?
- Is the lease term relevant for drawing up the balance sheet?
Junior Audit Manager at RSM Poland
Under the balance sheet law, if lease was concluded for a period of more than 75% of the economic life of the leased asset, it should be recorded in the balance sheet as finance lease. How can the entrepreneur check if the lease they concluded meets this requirement and thus must be recognised accordingly in the books?
Let us start by defining the key concept, i.e. the useful life of the leased asset:
The useful life of an asset in a company is the time it is planned to remain in use for operational activities (with economic benefits being derived from it). An entrepreneur who accepts a production machine or a delivery truck into their fixed asset register can never be sure how long it will be useful; for this reason, the useful life is an estimate subject to verification at least at the balance sheet day (in accordance with the Accounting Act).
An entrepreneur – especially one who keeps full books of account – should answer many questions about the leased asset already at the stage of accepting new assets to their register and determining the usable life of those assets. Article 32(4) of the Accounting Act stipulates that when defining the economic life of a fixed asset, you must take into account the following:
- the level of use of the fixed assets and their performance and vulnerability to damage: the useful life of a car used by a sales representative covering up to tens or thousands of kilometres will be determined differently than in the case of a car intended for executives who make occasional long journeys;
- possible refurbishment costs and estimated repair costs: bear in mind both the issue of the cost and availability of spare parts, as well as the level of complexity of potential repairs, as these are also relevant for useful life estimates;
- rate of technological changes: for some assets, the rapid development of technology and the withdrawal of obsolete products (and their spare parts) from the market may make it necessary to replace them, which clearly should be included in the analysis;
- legal or other limitations on the time of use: in the case of a lease, the parties to the agreement set a time frame for the use of the asset; however, this does not mean that it cannot be shorter. Therefore, you need to ask yourself another question here: if shorter, by how much? And why exactly so?
How to estimate the useful life of a leased asset?
Businesses wishing to estimate the useful life of a leased asset can rely on National Accounting Standard No. 5 (item 4.2.3.). According to this NAS, in determining it, either the useful life of a comparable asset or the economic useful lives underlying commonly used depreciation rates should be applied.
In the first case, you will be rescued by the accounting policy, where you will find the estimated useful lives of leased assets broken down into various asset categories.
In the second case, you can rely on the register of the Classification of Fixed Assets along with Appendix No. 1 to the Corporate Income Tax Act (CIT Act). This register allows you to assign your leased asset to a specific group of fixed assets, while Appendix No.1 to the CIT Act provides depreciation rates for different groups of fixed assets. By combining the information from both sources, you can determine that group 741 (passenger cars) has a depreciation rate of 20%, which is equivalent to a 5-year economic useful life.
In addition to the Polish balance sheet law (which is not always sufficient to exhaust the subject), it is undoubtedly worth looking at the provisions of International Accounting Standard 16 discussing ‘Property, Plant and Equipment’. IAS provisions are more precise and indicate that the useful life of an asset is defined as the period over which an asset is expected to be available for use by an entity.
How to check whether your lease term exceeds the 75% economic life threshold?
Let us imagine you have to decide on how to classify the following three leases for your balance sheet purposes:
- the first lease is for a passenger car; the lease term is 4 years, and the vehicle is for a sales representative,
- the second lease is also a passenger car lease. Its term is also 4 years, but the vehicle is for a CFO,
- the third lease is about a production machine. The lease term is 4 years, and the machine is for metal processing with an innovative method.
Under the accounting policy, the economic lives shall have the following time frames:
- Means of transport: 5-7 years;
- Machinery and equipment: 7-10 years.
Example 1: lease of a car for a sales representative
The purpose of the leased asset makes a factor that stands out here. A car used by a sales rep may have a mileage of up to 300,00 kilometres after 4 years. Even so, the car may remain in working order and continue to be used; however, its level of wear and tear is already significant.
In this case, a 5-year overall economic life should be considered as the lowest benchmark among those provided for by the accounting policy. A 4-year lease thus exceeds the 75% economic life threshold, and should therefore be recognised in the balance sheet as a finance lease (regardless of whether the remaining criteria are met or not).
Example 2: lease of a car for a CFO
Again, the purpose of the passenger car plays a crucial role here. Even though a lower level of car use is not the rule, it will probably not be as high as that of a sales representative’s vehicle. This, in turn, allows you to assume that the car will have a longer economic life than an identical model used by a sales rep.
In this case, adopting a 7-year overall economic life for a CFO’s car will be as reasonable as it can get. At the same time, this will mean that the 75% economic life threshold will not be exceeded, so this is an operating, off-balance sheet lease (assuming that other statutory conditions are not met).
Example 3: lease of a production machine
When using a machine for an innovative method of handling the production process, you can automatically assume that technologically the machine can serve the company for many years. If a brand-new machine is leased, you can assume there is no need for any major overhaul expenditure (apart from the costs anticipated for planned and natural tear and wear and the replacement of small parts). However, depending on the load resulting from the number of production cycles processed, the economic life of the machine may change.
Assuming such a scenario, it is by far the best to set the overall useful life at 10 years. Therefore, this is a finance lease again, because the machine will be used in the company for more than 75% of the economic life provided for in the accounting policy for machinery and equipment.
Classification of finance lease is essential for a correct balance sheet
As you can see, the lease is not as black as it is painted. Determining the economic life should not be problematic as long as you look at each and every contract in a broader perspective.
For the entrepreneur, of course, the safest solution is to rely on professional support and come up with procedures for different leases that can be followed in the future. For this reason, if you have any questions or concerns about lease qualification, we encourage you to contact us and follow our blog: in the coming articles we ae going to discuss the ways to determine the future value of a lease and the loss of its value over time.