There
has long been a principle of financial reporting that, in deciding the
appropriate method to record transactions, economic substance should
take precedence over legal form. This is the basis of FRS 5 Reporting
the Substance of Transactions, issued in 1994, to deal with the many
complex transactions that had developed as a consequence of the
ingenuity of the financial experts. We discuss FRS 5 in the first part
of this chapter. A very important example of the substance over form
principle is to be found in the accounting treatment of leases. Indeed,
so important is the example that the ASB produced a standard on the
subject, SSAP 21 Accounting for Leases and Hire Purchase Contracts in
1984, some ten years before FRS 5 saw the light of day. SSAP 21
distinguishes between two different categories of lease – finance1 and
operating leases respectively, and requiresvery different accounting
treatments of each. A lessee is required to capitalise a finance lease,
that is to recognise both a fixed asset and a liability, charging
depreciation of the asset and an interest or finance charge in respect
of the liability in its profit and loss account. A lessee must not
capitalise an operating lease, rather the rentals payable should be
charged to the profit and loss account in accordance with the accruals
concept. The accounting treatment of leases by the lessor mirrors the
treatment by the lessee. In the second part of this chapter, we explore
the issues involved in the treatment of leases and explain the
provisions of SSAP 21 in some detail. We illustrate the accounting
treatment of finance and operating leases by both lessees and lessors.
The provisions of the international standard IAS 17 are similar to those
of SSAP 21 although there are differences, especially in the treatment
of the income from finance leases by lessors.
In
recent years, the view has emerged, both in the UK and overseas, that
it is unrealistic to attempt to make a distinction between the two
categories of leases and that in conceptual terms a strong case could be
made for requiring the capitalization of all non-cancellable leases. We
explain this view, which is promulgated in two Discussion Papers issued
by the G4+1 group, a view that now has strong support from both the ASB
and the IASB, although it has yet to emerge in the form of an exposure
draft.