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SSAP 21: Accounting for leases and hire purchase contracts In August 1984, when SSAP 21 was issued,

the reason for its introduction was des cribed as follows. Leasing and hire purchase contracts are means by which companies acquire the rig ht to use (lease) or purchase (hire purchase) fixed assets. In the UK there is n ormally no provision in a lease contract for legal title to the leased asset to pass to the lessee during the term of a lease. In contrast, under a hire purchas e contract the hirer may acquire legal title by exercising an option to purchase the asset upon fulfilment of certain conditions (normally the payment of an agr eed number of instalments). Lessors fall into three broad categories: (i) companies, including banks and fin ance houses, which provide finance under lease contracts to enable a single customer to acqui re the use of an asset for the greater part of its useful life; (ii) they may operate a business which involves the renting out of assets for varying periods of time probably to more than one customer; or, (iii) they may be manufacturer or dealer lessors who use leasing as a means of m arketing their products, which may involve leasing a product to one customer or to several cust omers. As a lessor and lessee are both parties to the same transaction it is appropriat e that the same definitions should be used and the accounting treatment recommended should ideal ly be complementary. However, because the pattern of cash flows and the taxation conseque nces will be different, this will not mean that the recorded balances in both sets of financi al statements will be the same. There are two types of leases: finance leases and operating leases. The distinct ion between a finance lease and an operating lease will usually be evident from the contract between the lessor and the lessee. A finance lease usually involves repayment to a lessor by a lessee of the full cost of the asset together with a return on the finance provided by the lessor. As such, a lease of this type is normally non-cancellable or cancellable only under certain conditions, and the l essee enjoys substantially all the risks and rewards associated with the ownersh ip of an asset, other than the legal title. (This is very similar to a hire purc hase contract.) An operating lease involves the lessee paying a rental for the hire of an asset for a period of time which is normally substantially less than its useful econom ic life. The lessor retains the risks and rewards of ownership of an asset in an operating lease and normally assumes responsibility for repairs, maintenance an d insurance. SSAP 21 requires that a finance lease should be accounted for by the lessee as i f it were the purchase of the proprietory rights in an asset with simultaneous recognition of the obligation to make future payments, in the same way that a hire purchase is normally accounted for. Under an operating lease, only the rental will be taken into account by the lessee. The a sset involved does not appear in the balance sheet of the operating lease lessee. The standard reco gnises that the substance of a transaction rather than its legal form should govern the accounti ng treatment. The international standard on this topic, IAS 17 (Leases) has virtually the same requirements as SSAP 20.

Learning outcomes You should now have learnt: 1 Hire purchase is a means of buying assets where: (a) the asset does not belong to the purchaser until the final instalment is pa id and the purchaser agrees to a legal option to buy the asset; but (b) for accounting purposes, the asset is treated immediately as if it belonged to the purchaser. 2 Each payment made on a hire purchase contract is part interest and part payment of the cash price of the asset. 3 How to record the various entries relating to hire purchase. 4 How to treat hire purchase transactions in the trading and profit and loss account and balance sheet. 5 The difference between hire purchase and leasing. 6 The difference between a finance lease and an operating lease. Answers to activities 2.1 An organisation may have a shortage of cash, or may prefer to use its ca sh for other purposes. It may not wish to keep the asset permanently and may buy it on hire purchase so that after a couple of years it can stop paying the instalments. Sometimes, hir e purchase is offered at zero interest so it is actually cheaper to purchase an item on hire purchase (because interest can be earned by the buyer on the amount not yet paid). 2.2 Because 48 less was paid in Exhibit 2.2 at the end of Year 1. Interest wa s charged at 10% on that 48, resulting in an additional 4 having to be paid in Year 2 as well as the 48 that was not paid in Year 1. Overall, this meant that the Year 2 payment in Exhibit 2.2 was 52 greater than in Exhibit 2.1. However, over the two years, the difference in cost to the buyer wa s the 4 interest that arose as a result of the first-year payment having been slightly lower in E xhibit 2.2