Transitioning to FRS 102 is a transformational experience for any business. Most organisations already understand the initial goal, evaluating the lease portfolio, and determining the project scope. However, two critical areas often require deeper exploration: Value Added Tax (VAT) and the Retail Price Index (RPI).
What is value added tax (VAT)?
Value Added Tax is a percentage of tax passed down the supply chain for goods and services. As a business purchases inventory and sells it for a profit, VAT is added to the charge at every stage.
Example of VAT: The “lemonade” lifecycle
To understand how VAT impacts a business, let’s follow the journey of a lemon for George’s Lemonade Stand:
- The Farm: A farmer sells lemons to a store for $1.00/lb plus a 20% VAT ($0.20). The store pays $1.20 total. For the farmer, that $0.20 is output tax; for the store, it is input tax.
- The Store: George buys the lemons from the store for $5.00/lb plus 20% VAT ($1.00). George pays $6.00 total. For the store, that $1.00 is output tax; for George, it is input tax.
- The Stand: George sells 10 cups of lemonade (using 1 lb of lemons) at $3.00 each for a subtotal of $30.00. He charges his customers a 20% VAT ($6.00), receiving $36.00 total. For George, this $6.00 is output tax.
To calculate the Value Added Tax (VAT) a business owes the government, you simply subtract its input tax (the VAT the business paid to suppliers) from its output tax (the VAT it charged to its own customers). Looking at our example, when George sells his lemonade, he collects a 20% output tax of $6.00. However, because he already paid a $1.00 input tax to the store when buying his lemons, he gets to credit that amount. When it’s time to file his taxes, George subtracts that $1.00 from the $6.00 he collected, leaving him owing the government just the $5.00 difference.
Recoverable vs. non-recoverable VAT
While most VAT is recoverable (meaning the business receives a credit back), there are exceptions:
- Non-Recoverable VAT: These are business transactions that do not qualify or allow the business to recover the tax credit. This could include gifts or entertainment outings for the staff or customers. The VAT incurred would be a direct expense for the business and not considered as recoverable.
In the majority of lease scenarios for a business, the VAT incurred would be recoverable for the business. The main exception to this would be leases that include personal use, the most common example being vehicles, where the 50% rule may be implemented.
- The 50% Rule (Vehicles): Under FRS, if a company car has any personal use, the business is legally blocked from reclaiming 50% of the VAT on the finance element. This irrecoverable 50% must be treated as a direct expense.
When evaluating lease accounting solutions for the FRS 102 transition, ensure that the system contains a method for tracking the assets that fall under the 50% rule. This will save tax teams from searching and reviewing all contracts to find which assets qualify and which ones need the 50% rule applied.
VAT and lease accounting
When dealing with lease portfolios, such as leased vehicles, businesses often ask how to properly treat VAT. While some may be tempted to include VAT in their liability and asset calculations (fixed consideration), this is generally not the practice.
Organisations must ensure that the business is evaluating additional costs and whether that cost is fixed, variable, or tied to an index. For context, a fixed component would be included in the minimum future lease payments; variable components can be changed or adjusted without reconfiguring the contract terms, and index payments under FRS and IFRS are included in the principal and will adjust the schedule accordingly.
When we look at VAT using this concept, we can consider the following:
- Variable Payment Status: Legally, VAT is a variable payment rather than a fixed consideration for the use of the asset.
- The Invoice Trigger: You do not “owe” ten years of VAT today. You only recognize VAT when a specific invoice is issued, known as the “Tax Point”.
- Pass-Through Logic: Because VAT is generally recoverable, it flows through the balance sheet as a receivable rather than hitting the P&L as a cost.
Transitioning from tax to inflation
While managing VAT ensures your balance sheet reflects current tax obligations, long-term lease accuracy also depends on how you handle future economic shifts. Beyond tax considerations, businesses must account for scheduled rent adjustments tied to national inflation markers.
Managing economic adjustments: CPI vs. RPI
In many long-term leases (especially in the UK and Ireland), base rent is tied to inflation indices. Understanding how the index rates can and will impact your lease portfolio is necessary to ensure teams are not faced with last-minute corrections and true-up journal entries.
While the rates we are about to discuss are the most common index-related payments, businesses may find themselves with additional costs tied to indices and will need a solution that can handle the accounting implications.
- CPI (Consumer Price Index): Generally used for official government targets. It excludes most housing costs, often resulting in a lower inflation rate.
- RPI (Retail Price Index): An older measure that includes housing costs and uses a mathematical formula that typically results in a higher rate.
The accounting impact
Under IFRS 16 and FRS 102, when an index like CPI or RPI changes, you must remeasure your lease liability. This means that every time the rate is adjusted, the business will receive a new liability balance and a change in assets and will need to book the journal entry accordingly to reflect that change in balance.
If an organisation is performing this manually, this process can take many hours, as the business must determine the rate, adjust the new payment to reflect the new RPI, and then re-amortize all schedules in accordance with change in payments. This would need to be repeated for each schedule that references Retail Price Index for compliance.
Summary
Transitioning to FRS 102 involves navigating technical nuances like VAT recovery and inflation-linked adjustments. While VAT is generally treated as a variable payment and kept off the lease schedule due to its recoverable nature, RPI and CPI adjustments require active remeasurement of lease liabilities. Properly managing these economic factors ensures your balance sheet remains accurate and prevents the need for complex year-end corrections. Organisations should look for solutions that automate these recalculations to maintain compliance efficiently.
