Ssap 21 Finance Lease Accounting

SSAP 21, Accounting for Leases and Hire Purchase Contracts, provides guidance on how companies should account for leases and hire purchase contracts in their financial statements. It distinguishes between two primary types of leases: finance leases and operating leases.

A finance lease (also known as a capital lease) is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. This means that, in substance, the lessee is acquiring the asset even though legal title remains with the lessor for the duration of the lease. Key indicators that a lease is a finance lease include:

• The lease transfers ownership of the asset to the lessee by the end of the lease term.
• The lessee has the option to purchase the asset at a price that is expected to be significantly lower than the fair value at the date the option becomes exercisable, such that it is reasonably certain that the option will be exercised.
• The lease term is for the major part of the economic life of the asset even if title is not transferred. Generally, a lease term exceeding 75% of the asset’s economic life is considered a major part.
• At the inception of the lease, the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset. A present value exceeding 90% of the asset’s fair value is generally considered substantial.
• The leased assets are of such a specialized nature that only the lessee can use them without major modifications.

Accounting for Finance Leases by the Lessee:

The lessee recognizes the asset and a corresponding liability (lease obligation) in their balance sheet at the inception of the lease. The amount recognized is the lower of the fair value of the leased asset and the present value of the minimum lease payments, each determined at the inception of the lease. The discount rate used to calculate the present value is the interest rate implicit in the lease; if this rate is not readily determinable, the lessee’s incremental borrowing rate is used.

The asset is depreciated over its useful life, or the lease term if ownership is not transferred by the end of the lease term. Depreciation should be consistent with the lessee’s normal depreciation policy for similar assets.

The lease payments are split between a finance charge (interest expense) and a reduction of the outstanding lease obligation. The finance charge is recognized as an expense in the profit and loss account over the lease term, so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period.

Accounting for Finance Leases by the Lessor:

The lessor derecognizes the leased asset from their balance sheet and recognizes a lease receivable, representing the present value of the minimum lease payments plus any unguaranteed residual value. The difference between the gross investment in the lease (the sum of the minimum lease payments plus any unguaranteed residual value) and the present value of the gross investment is recognized as unearned finance income.

The unearned finance income is recognized as revenue over the lease term, so as to produce a constant periodic rate of return on the lessor’s net investment in the lease.

SSAP 21 provides detailed guidance and examples to assist companies in applying these principles. Proper application of SSAP 21 ensures that the economic substance of lease transactions is accurately reflected in the financial statements, providing users with a true and fair view of a company’s financial position and performance.