IFRS 16: Accounting for salary sacrifice vehicles

Company law recognises two financial reporting frameworks in the UK:

• UK-endorsed international accounting standards (referred to as International Financial Reporting Standards, or IFRS, within this guide), and
• UK Generally Accepted Accounting Practice (referred to as UK GAAP, within this guide).

Since its introduction, the lease accounting standard has been applied to organisations reporting under IFRS, which initially included publicly listed companies and their subsidiaries. However, it now applies more widely with certain public sector bodies required to apply international accounting standards; for example, local authorities and maintained schools have been required to apply IFRS 16 from April 2024. Other organisations report using UK GAAP.

IFRS 16 represented a significant change to lease accounting when it came into effect in January 2019, and may have a material impact on the financial statements of lessees of property and high-value equipment such as vehicles. This is because it requires the adoption of a fundamentally different approach to accounting for leases; the ‘right-of-use’ model.

Broadly speaking, where an entity has control over, or the right to use, an asset it is hiring, it is classified as a lease for accounting purposes. Under the international accounting standard, the lease payments must be recognised as a liability on the company’s balance sheet, alongside a corresponding, and usually equal, asset representing the ‘right-of-use’ of the leased asset.

Hence, IFRS 16 prevents significant financial liabilities from being held off-balance sheet, as currently permitted for certain types of leases (operating leases) under UK GAAP. The objective of IFRS 16 is to ensure that entities report information for all of their leased assets in a standardised way in order to bring transparency and consistency to their leased assets and liabilities.

As with other changes to accounting standards, entities adopting IFRS 16 for the first time will also need to produce a set of comparative accounts for the prior year.

IFRS 16 replaced International Accounting Standard (IAS) 17. Under IAS 17, and current UK GAAP, the accounting treatment for a lease depends upon whether it is classified as a finance lease or an operating lease.

Under IFRS 16, a lessor shall classify each of its leases as an ‘operating lease’ or a ‘finance lease’:-

• A lease is classified as a finance lease if it transfers to the lessee substantially all the risks and rewards incidental to ownership of an underlying asset to the lessee; whilst
• A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset to the lessee.
  

Under IAS 17, and current UK GAAP, a finance lease must be capitalised and reflected in the balance sheet. An operating lease, meanwhile, is merely charged to the income statement, which is still commonly referred to as the profit and loss (or P&L) account, with the associated rentals being recognised as an expense as they are incurred.

IFRS 16 works in a similar way to the reporting of other non-financial assets (such as property, plant and equipment) and financial liabilities:

Lessees must show their right-of-use asset as a fixed asset and their obligation to make lease payments as a liability, with the portion due within the next 12 months having to be included within current liabilities.

As the value of the right-of-use asset is the same as the value of the liability to make future lease payments at the outset of the lease, the asset and liability recognised within the balance sheet should be the same, so there should be no immediate impact on net assets.

Lessees will depreciate the asset and recognise interest on the lease liability. The depreciation would usually be on a straight-line basis, but the interest expense will be front-end loaded, with higher interest charges recorded in the early years of the lease, even though the lease rentals remain constant throughout the term of the lease.

The service element of the lease, such as the maintenance charge, does not need to be capitalised and will continue to be charged directly to the or P&L account.

Provided an entity can demonstrate there would be no financial advantage, rather than having to account for all leases individually, there is scope to combine these within a portfolio where the nature of the asset and the underlying lease terms are similar; for example, all car leases could be accounted for within a portfolio.

Entities broadly have to go through three stages to complete their IFRS 16 financial reporting:

Identify all assets which should be defined as leases under IFRS 16 (including property, equipment, vehicles, etc).

Collect all the relevant information on the identified assets, such as the term, rentals payable, interest rate, and options at the end of the lease. Where items such as the interest rate is not available, perhaps because it is commercially sensitive, the lessee should use its own incremental borrowing cost, which is the rate it would pay to borrow over a similar term for a similar security in a similar economic environment.

Calculate the leased assets and liabilities based on the information collected. Entities need to bear in mind that a net present value calculation must be undertaken, so calculating the value of the liability, and consequently the right-of-use asset, is not merely a case of multiplying the lease rentals by the lease term; the lease liability is calculated using discounted cash flow techniques using either the interest rate implicit in the lease or the company’s incremental borrowing rate.

Company cars are typically leased via a long-term contract hire agreement over a 2, 3 or 4-year term, which should be accounted for as leases because:

1. Having identified an asset (in this case, the car);
   1. The lease would not qualify as a low-value asset, given the typical value of a car; and
   2. The company has the right to the economic benefit arising from the use of the car during the term of the lease; and
   3. The company has the right to control the use of the car for a period of time in exchange for consideration; or
   4. Where the company's right to direct how and for what purpose a car is used throughout the term of the agreement has been predetermined, in common with standard contract hire agreements within which a lessor might define the scope of the lessee’s right-of-use, the supplier cannot change those operating instructions setting out the customer’s predefined rights, or the customer itself designed the asset in a way that that predetermines how and for what purpose it will be used.

Therefore as they constitute leases, organisations account for contract hire agreements in accordance with the lessee accounting treatment set out in IFRS 16; as such the underlying nature of the lease, that is whether it’s an operating lease or finance lease is no longer relevant for the lessee.

Interestingly, it's widely acknowledged by the leasing industry throughout the UK that contract hire agreements should be recognised and accounted for as leases.

For a comparison of the accounting treatment to be applied under IAS 17 and IFRS 16 please refer to the Appendix.

As the provision of a salary sacrifice car is undertaken using two agreements, it is necessary to consider the accounting for both the underlying contract hire agreement and the salary sacrifice agreement.

Salary sacrifice cars are typically leased by an employer via a contract hire agreement.

Accordingly, an employer that has adopted IFRS 16 should capitalise the lease liability and the right-of-use asset on the balance sheet, charging depreciation and interest to the P&L account.

The service element of the lease (this is the maintenance charge) does not need to be capitalised and should continue to be charged directly to the P&L account.

The employer and employee will enter into a separate agreement via which the salary sacrifice (leased) car is made available to the employee in return for the salary sacrifice.

It's reasonable for the salary sacrifice agreement to be recognised as a ‘sub-lease’ because it conveys to the employee the right-to-control the use of an identified asset (the car) for a period of time in exchange for consideration.

The sub-lease would then be recognised as an operating lease rather than a finance lease, and should be accounted for as per the lessor accounting treatment set out within IFRS 16, which effectively means that the salary sacrifice is credited to the P&L account only with no additional balance sheet implications.

Alternatively, the short-term employee benefit exemption available under IAS 19 could apply. Using this exemption, the salary sacrifice agreement should be accounted for solely via the P&L account, with no balance sheet implications.

Ultimately, whether the salary sacrifice agreement is accounted for as a sublease or otherwise, the accounting entries should be the same.

UK GAAP is the body of accounting standards published by the UK’s Financial Reporting Council.

Whilst listed companies, including AIM companies, and public sector organisations are required to use IFRS in their consolidated accounts, they may choose between IFRS and UK GAAP in their individual company accounts.

Almost all other companies have a choice between preparing their accounts under UK GAAP or IFRS.

• FRS 101 sets out an optional reduced disclosure framework for the individual accounts of qualifying subsidiary and parent companies that otherwise apply IFRS;
• FRS 102 sets out the reduced disclosure financial reporting requirements for entities that are not applying FRS 101 or FRS 105; and
• FRS 105 is the accounting standard (the standard that applies to very small companies, referred to as micro-entities), which enables them to keep a simpler set of accounts than those required of small, medium or large companies.

In summary, FRS 102 is classified as ‘The financial reporting standard applicable in the UK and Republic of Ireland’ and it applies to the financial statements of all entities that do not use IFRS, FRS 101 or FRS 105. Issued in March 2013, it is subject to periodic review, with the latest, completed in March 2024, proposing some significant changes.

Significant changes to FRS 102 are due to come into effect for accounting periods starting on or after 1 January 2026, although early adoption is available to those who wish to proceed more quickly.

It means changes to lease accounting, with most of the requirements of IFRS 16 being brought into UK GAAP. The changes to FRS 102 Section 20 will require lessees to bring almost all leases onto the balance sheet, but the accounting for lessors will remain largely unchanged.

Under the revised standard lessees must recognise a right-of-use asset in respect of the lease contract, and a corresponding lease liability, being the present value of remaining payments under the lease.The lease liability will need to be discounted using the interest rate implicit in the lease; if that rate can't be readily determined, the company’s incremental borrowing rate should be used.

The right-of-use asset must be depreciated over the remaining term of the lease, and the lease liability unwound as cash payments are made. The result is that the operating lease expense is replaced by a depreciation charge on the right-of-use asset and a finance charge on the lease liability.

As for IFRS 16 there are certain exemptions; for example, short-term leases (including those with less than 12 months remaining at the transition date) or leases for assets of low value can continue to be accounted for as operating leases, taking the rental expense to the P&L over the course of the lease term.

Businesses won't be required to go back and reconsider whether an arrangement constituted a lease prior to the transition date. Nor will prior year restatement be required, with the impact of the transition being posted as an adjustment to opening reserves on the transition date.

Company cars are typically leased via a long-term contract hire agreement over a 2, 3 or 4-year term; these should be accounted for as leases with a right of use asset and lease liability recognised on the balance sheet and depreciation and interest charged to the P&L account.

As the provision of a salary sacrifice car is undertaken using two agreements, it is necessary to consider the accounting for both the underlying contract hire agreement and the salary sacrifice agreement.

Salary sacrifice cars are typically leased by an employer via a contract hire agreement.

An employer should capitalise the lease liability and the right-of-use asset on the balance sheet, charging depreciation and interest to the P&L account.

The service element of the lease, in this case the maintenance charge, does not need to be capitalised and will continue to be charged directly to the P&L account.

The employer and employee will enter into a separate agreement via which the salary sacrifice (leased) car is made available to the employee in return for the salary sacrifice.

The salary sacrifice agreement will constitute a sub-lease, with the nature of that sub-lease being dictated by the nature of the lease for the car itself; because that head lease will be classified as an operating lease the sub-lease will be accounted for as an operating lease per the lessor accounting treatment set out within FRS 102, with the salary sacrifice being credited to the P&L account as income only and no balance sheet implications.

The above constitutes our Octopus EV interpretation, with external guidance from BCF Wessex, of the IFRS 16 and FRS 102 lease accounting treatment that typical schemes should apply in respect of the contract hire and salary sacrifice agreements.

However, we want to be clear that this is our interpretation of the lease accounting standards, based on the generally adopted vehicle leasing market treatments, which we have compiled in order to help customers consider their treatment for accounting purposes.

As Octopus EV do not provide accountancy related advice, nor provide professional advice due to the complex nature of customers businesses and accounting practices, we always recommend that customers engage with their own auditors and guidance partners; as they are typically best placed to support them in determining their own interpretation and adoption of accounting practices to be applied for an employee salary sacrifice car scheme.

In partnership with BCF WESSEX

BCF Wessex are tax and software consultants to the automotive industry. Their Gensen software offers industry-leading tax and sales calculations focused on speed and accuracy for OEMs, leasing companies and brokers.