Read our guide to lease accounting for lessees, with special considerations for non-profits
Overview: motive and the accounting solution for leased assets
For-profit accounting has an underlying focus on the capability of an entity to generate cash flows with the primary purpose of providing a financial return to the providers of risk capital.
In the operating context of for-profits, the leasing of an asset involves the provision of an asset by the lessor for a commercial return and the contract represents a claim on the assets of the lessee for the term of the lease. Were the updating UK-Irish Generally Accepted Accounting Practice (GAAP) to bring operational leases on balance sheet (statement of financial position), then the accounting would look to differentiate the underlying value of the asset to the lessee from the return on capital (the financing element) due to the providers of risk capital (the lessor). The motivation of the lessee is to deploy the leased asset to generate financial returns greater than the cost, including financing cost, incurred in holding the asset over the term of the lease.
For investors, knowing the extent of financing costs, the different rates of return enjoyed by different classes of providers of capital and the claims on an entity’s cash flow are important commercial considerations when making investment decisions. It is contended that in large part these commercial considerations simply do not apply to most non-profits, especially charities. If this is true then the accounting should reflect this.
It is accepted that cash flow considerations can apply where non-profits, for example charities, lease assets in order to generate cash flows and surpluses as a source of income; however, for many non-profit entities assets are leased for other reasons.
These alternative motives are important to the fair representation of general purpose financial statements which are intended to inform decision-making by users for whom rate of return on risk capital is perhaps an irrelevance. For example, in the case of charities, matters of financial resilience, the available funds to carry out its work and most importantly the use to which those funds are put are the matters affecting decision-making by stakeholders who are essentially focused on public benefit.
Proposal: modify the accounting solution for lease accounting by lessees where cash flow is not the principal consideration
The author proposes modifying the approach to lease accounting by non-profits leasing assets for operational purposes where the generation of cash flows is of secondary importance or is incidental to the delivery of public benefit.
The proposed solution, referred to as a ‘modified approach’, would add PBE paragraphs to section 20 of FRS 102 with the emphasis being on identifying and disclosing the nature of the leased assets, the motivation for leasing them and measuring the claim that the leasing arrangements place on the funds of the non-profit entity.
To aid simplification, the options to measure the liability of a lease without adopting net present value techniques are recommended on the basis that distinguishing the intrinsic financing element is of little import to decision-making by stakeholders of non-profits.
Evidence for the public benefit being the primary motivation of stakeholders is well established from the research into public and donor attitudes by the charity regulators: Charity Commission for England and Wales and the Office of the Scottish Charity Regulator
A number of non-profit scenarios are identified with a proposed solution and supporting rationale (basis for conclusions) for each.
2A Lease arrangements involving annual ‘peppercorn rents’
The practice of offering a ‘peppercorn rent’, defined as annual lease payment of a low or nominal value, is a mechanism for the lessor to retain an interest in the underlying asset without seeking cash flows and a market return for the leased asset.
In the context of non-profits this practice is typically a mechanism for the lessor to ensure that the leased asset is used for a mutually agreed purpose for the public benefit under the terms of the lease. These leases tend to have long terms and may in some instances in substance be equivalent to a transfer of freehold, for example where a building is sold with leasehold of a 99 or even 999 term with a nominal ground rent payable.
In fettering the lessee the lessor is seeking to safeguard the fulfilment of the social purpose for which they have made the asset available to the lessee and/or looking to minimise or remove the discretion of the lessee to deploy the asset for another purpose without the prior agreement of the lessor, by way of a new lease or a variation to the lease terms of the existing lease. Were the lessee to breach the terms of the lease then the lessor could recover the asset, thereby preserving its use for the social purpose to the public benefit intended by the lessor.
Were the operational lease model discontinued, it is proposed to substitute the options of either:
The advantages of each approach in the context of charities are:
The caveat to the treatment as an intrinsic cost to the acquisition or construction of a building on land subject to a lease is that the lessee cannot dispose of the leased land separately from the building. Since land is not normally depreciated it is proposed that that portion of the lease term that falls outside the economic life of the building is capitalised but treated as a residual value and is not depreciated. Then if the building is sold the non-depreciated component as in the carrying value at time of disposal or if a building is replaced then that portion of the lease that falls within the economic life of the new building is treated as a component of building cost.
The suggested modification to FRS 102 would provide for a glossary term and a specific accounting treatment and disclosures for peppercorn lease arrangements apply.
Glossary entry
‘Peppercorn lease’ is a lease arrangement which is not classified as a ‘short lease’ under this standard where the consideration payable under the lease is of low value or a nominal value as compared to the prevailing market rate for a lease of similar term.
Accounting treatment: Provision with an annual rental equivalent model
On initial recognition, measure at full cost for the lease term and treat as a provision in other comprehensive income (in the Charities SORP the provision is of a similar character to a designation of funds intended to show a commitment to future expenditure).
In each year charge to expenses a proportion of the lease on a straight-line basis as an annual rent with the offset against the provision with the cash flow of lease paid in year reducing the creditor balance.
Illustrative double entry for a 25-year lease with an annual payment of 1,000 currency units is therefore 25,000 currency units (not discounted) for full term.
At inception:
In each year of the lease term:
Full provision on acquisition model
On initial recognition the value of the lease payments for the term of the lease are aggregated and included within the cost of the asset with a corresponding creditor for the lease. The economic (or service) life of the asset and the lease term are both 25 years. The 25-year lease has an annual payment of 1,000 currency units and therefore 25,000 currency units (not discounted) is due over the full term:
In each year of lease term:
In cases where there is a residual value, for example a property, then the residual element is retained in the carrying value and not depreciated.
In the example, on initial recognition the value of the lease payments for the term of the lease are aggregated and included within the cost of the asset with a corresponding creditor for the lease. The economic (or service) life of the asset is 10 years, but the lease term is 25 years; 15 years of lease payments represent a residual value of 15,000 currency units:
The economic (or service) life of the asset is 10 years, but the lease term is 25 years; 15 years of lease payments represent a residual value of 15,000 currency units but over the 10 year life of the asset only 10,000 currency units will be paid by the lessee. In each year of lease term:
Disclosure
At initial recognition only:
Both at recognition and for each subsequent reporting period:
2B Leased assets retained by a charity for a social purpose rather than generating cash flows
Unlike for-profit entities, many non-profits do not seek to trade but instead rely on voluntary income and gifts (or grants) to operate. In these cases, a leased asset is not being used to trade and generate cash flows. The leased asset is instead used for the public benefit to provide social goods, services, facilities and amenities to beneficiaries at nil or a nominal charge. To apply accounting solutions developed for the for-profit sector to these situations is wholly misplaced and its outcome in terms of treatment and disclosure provides information of little or no value to stakeholders (refer to research evidence cited earlier from studies carried out by UK charity regulators).
Calculating a notional right of use separately from the financing cost in order to match the notional depreciation with the repayment of principal element of the lease misunderstands the use of the asset since it is not retained for trading and cash flow generation; instead the operational lease model that looks to incorporate a simple cost of use is a better model because it is closer to the substance of the arrangement of an annual rent. Since the operational lease model is being discontinued, it is proposed to substitute an annual rental equivalent.
Treatment: see section 2A above
Disclosure: see section 2A above
2C Leased assets used to convert donated items into cash flow where the income generated enjoys relief from tax as non-taxed trading
To encourage the work of non-profits, in particular charities, relief from taxes is offered where donated items which are not retained for the charity’s own use is converted into cash. To facilitate this activity, charities may lease shop premises or lease store room facilities in support of on-line trading.
Selling gifted items falls outside of the IFRS 15 definition of revenue; the examples of revenue given in paragraph 26 do include ‘resale of goods purchased by an entity (for example, merchandise of a retailer)’ but gifted items by definition have not been bought for resale.
To support these activities intended to provide public benefit, rates relief and other support is offered. Since the trading is not subject to the for-profit operational context of taxation on trading profits, the option to take a modified approach to shop leases is recommended. The annual rental equivalent approach better represents the operational impact of the lease and is more easily understood by trustees and stakeholders alike. For trustees it means that they understand at the point of signing the lease that they have entered into a legally binding commitment to make the lease payments and the provision is a prior call on the available resources for current and future charitable activity.
The annual rent equivalent is more easily understood as they rent a space that they do not own and the amount of the annual rent equates to the cash flow. For stakeholders, most of whom are donors and beneficiaries, the provision has shown the resource now tied up in future lease payments which is no longer available for charitable activity and the annual rent is clearly shown as a cost of converting donations into income in year.
Glossary entry
Income from non-taxed trading is income generated by an activity that is relieved from income, capital gains, and sales taxes.
Treatment: see section 2A rental equivalent option
Disclosure: see section 2A above
2D Leased assets where cash flow is a secondary consideration- ‘social investments’ as defined by the Charities (Protection and Social Investment) Act 2016
Reforms to charity law applying in England and Wales looked to recognise and encourage investment activities where financial return on capital is either a secondary or partial consideration to the investment decision and instead the investment is made to advance an activity for the public benefit.
Section 15 of the 2016 Act inserts section 292A to the Charities Act 2011. This amendment provides that ‘a social investment’ is ‘where a relevant act of a charity is carried out with a view to both a) directly furthering the charity’s purposes; and b) achieving a financial return to the charity’. Since the lessor has entered into the transaction without the profit motive of making a commercial risk-adjusted market rate of return on the lease, treating the lease in regard to the lessee as a commercial lease misunderstands the use of the asset.
The leased asset is instead used for the public benefit to provide social goods, services, facilities and amenities to beneficiaries in furtherance of the lessor’s charitable objectives. To apply accounting solutions developed for the for-profit sector to these situations is wholly misplaced and its outcome in terms of treatment and disclosure provides information of little or no value to stakeholders (refer to research evidence cited earlier from studies carried out by UK charity regulators).
In respect of social investments, the annual rental model is a better representation of the motive and substance of the lease.
Treatment: see section 2A above
Disclosure: see section 2A above
2E Concession for small entities with leased assets used to generate cash flows but with no right or option to sublet under the terms of the lease
The author accepts that in principle leased assets used by lessees for trading to raise funds for their charity is directly comparable to trading to generate a financial return for the providers of risk capital; however, differentiating the element of imputed financing costs and deriving a principle element equivalent to the notional value of the right of use in order to provide information to providers of risk capital is of little relevance to most stakeholders of charities.
However, since the underlying motive of using a leased asset to trade in order to generate cash flows is in common with for-profit entities, the argument to consistently apply the approach to recognition and measurement of like transactions is accepted as an over-riding one. In regard to disclosure lessors would expect equivalence in disclosures too.
The charity sector though is skewed towards very small entities and has a high volunteer element and so it is proposed that the approach is simplified to allow smaller charities to treat the in year lease payment as a rent. The main reason for the simplification being that trustees and most stakeholders of these smaller charities will better understand the liability presented in this way and so the information will be of greater value to decision-making about the charity.
In respect of larger charities that are likely to have a greater scale of operations and/or trading activities the for-profit solution is more appropriate as the decision-making of lessors and providers of risk capital is likely to be an important stakeholder group and having information in a form that they encounter in the for-profit sector will assist their decision-making and so in turn will better serve trustees.
The absence of an ability to sublet the lease means that the asset can be treated as a commercial investment and is wholly retained for exclusive use by the charity to generate cash flows for future charitable activity. This limitation is key since otherwise the charity could either acquire or opt to treat leased assets as a commercial investment portfolio, in which case the for-profit model based on returns on capital has a direct relevance.
Treatment: see section 2A rental equivalent option
Disclosure: see section 2A above
About the author
Nigel Davies FCCA was until January 2022 Joint Chair of the Charities SORP Committee and of the SORP-making body responsible for the development of the Charities SORP.