Finance Leasing Manual - FLM4.30

SSAP21: borderline between finance and operating leases: intention

The original intention was that the SSAP 21 borderline between finance and operating leases (see FLM4.29) would be applied with common-sense and in the light of its spirit. However its spirit was not adhered to by those who wished to adopt an essentially mechanical approach to the rules, in order to present the commercial accounts in the best possible light. For example, if a lessee wanted a lease to be an operating lease it could structure it so that the present value of the minimum lease payments amounted to only 89% of the fair value of the asset. This is not tax avoidance but Companies Act or accountancy rules avoidance.

Difficulties did not arise only because of attempts to massage accounts. As financing arrangements grew more sophisticated it became increasingly hard - even with the best will in the world - to decide whether a lease was a finance lease or an operating lease. Moreover, the 90% test (see FLM4.29) usually involved an element of judgment which could be exploited. What was the fair value of the asset? Valuers could take different views. What was the present value of the minimum lease payments? Calculating that sum could involve estimating future interest rates and also any residual value of the asset which the lessor could keep. In short there was a fair amount of scope for taking a pessimistic or optimistic view of a range of possible numbers.

The Accounting Standards Board therefore tried to discourage abuse of the spirit of SSAP 21 by issuing FRS 5 (Financial Reporting Standard 5: Reporting the substance of transactions) in 1994, see FLM4.28.