Contract Hire: A Practical Guide

The transition to contract hire for company vehicles can present a steep learning curve, particularly when it comes to accounting treatment. Many businesses are being advised to account for contract hire agreements as if they were finance leases, a concept that, while theoretically understood, often requires practical clarification. This article aims to demystify the process, providing a step-by-step approach to managing contract hire vehicles in your company's financial statements, drawing parallels with finance lease accounting principles.

Understanding Contract Hire and Finance Leases

Contract hire is essentially a long-term rental agreement where a business pays a fixed monthly fee for the use of a vehicle. Unlike outright purchase, the company doesn't own the asset. However, when accounting for these arrangements as finance leases, the core principle is to reflect the economic reality: the company is gaining the significant risks and rewards of ownership, even if legal title remains with the lessor. This means the vehicle and the associated liability must be recognised on the balance sheet.

1. Determining the Value for Capitalising the Vehicle

The first crucial step is to establish the initial value of the vehicle for capitalisation. This should represent the fair value of the asset at the commencement of the lease or, if lower, the present value of the minimum lease payments. For contract hire, the minimum lease payments typically include the initial payment and all subsequent regular payments over the lease term. The challenge often lies in determining the appropriate discount rate to calculate the present value. Generally, this should be the interest rate implicit in the lease, if readily determinable. If not, the lessee’s incremental borrowing rate should be used.

Key Considerations for Capitalisation Value:

• Fair Value: The market value of the vehicle at the lease start.
• Present Value of Minimum Lease Payments: Sum of all payments, discounted back to their present value.
• Discount Rate: The interest rate implicit in the lease or the lessee's incremental borrowing rate.

Often, the contract hire agreement will specify the 'capital value' or 'capitalised cost' of the vehicle, which can serve as a strong indicator of the fair value. It's important to scrutinise the contract to identify these figures.

2. Apportioning the Charge to the Profit & Loss (P&L)

Once the vehicle is capitalised, the subsequent payments need to be split between reducing the lease liability (the capital portion) and recognising finance charges (the interest portion). This is typically done using the effective interest method, consistent with finance lease accounting.

The P&L charge for each accounting period will consist of:

• Depreciation Charge: The asset (vehicle) is depreciated over its useful economic life or the lease term, whichever is shorter. The depreciation method should be systematic and rational, with straight-line depreciation being common.
• Interest Expense: Calculated on the outstanding balance of the lease liability using the effective interest rate determined at the commencement of the lease.

Illustrative Example of P&L Allocation:

Assume a vehicle is capitalised at £20,000 with a lease term of 36 months and an effective interest rate of 5% per annum. The annual payment might be structured to cover both the capital repayment and the interest. In the first year, a portion of the payment will be interest, and the remainder will reduce the capital balance. The P&L will recognise the interest expense and the depreciation charge for the year.

*Note: The interest expense is calculated on the opening lease liability. The capital repayment is the difference between the total lease payment and the interest expense. Depreciation is typically based on the depreciable amount over the useful life or lease term.

3. Diminishing the Value of the Asset

The value of the asset on the balance sheet is reduced over time through depreciation. As mentioned, the vehicle is depreciated over its useful economic life or the lease term, whichever is shorter. The depreciable amount is the cost of the asset (or other amount substituted for cost, such as fair value at the commencement of the lease) less its residual value. In the context of a finance lease, the residual value is often assumed to be nil at the end of the lease term if the contract includes a purchase option at a nominal sum, or if the lessee is expected to return the vehicle in a condition that implies no significant residual value to the lessee.

Residual Value: This is the estimated value of the asset at the end of its useful life or lease term. For contract hire treated as a finance lease, careful consideration should be given to the terms of the contract, particularly regarding any buy-out options or return conditions, which can influence the assumed residual value.

4. Determining the Value of the Creditor

The liability to the lessor is recognised on the balance sheet as a lease liability or a finance lease obligation. This liability represents the total future lease payments that the company is committed to making. As payments are made, the liability is reduced. The liability is presented as current (payments due within 12 months) and non-current (payments due after 12 months).

Breakdown of the Creditor (Lease Liability):

• Initial Recognition: Equal to the present value of the minimum lease payments.
• Subsequent Measurement: Reduced by lease payments made. The interest component of each payment increases the liability, while the capital component reduces it.

The 3-month initial payment followed by 33 further monthly payments structure means that at any given point, there will be a portion of the liability that is due within the next 12 months (current liability) and a portion that is due beyond that (non-current liability).

IFRS 16 and Component Allocation

For context, recent accounting standards like IFRS 16 have introduced more detailed guidance on lease accounting. IFRS 16 requires lessees to recognise a right-of-use asset and a lease liability for most leases. It also mandates the separation of lease components from non-lease components within a contract, unless a practical expedient is applied.

A lease component is defined as the right to control the use of an identified asset. Non-lease components could include services like maintenance or insurance bundled into the contract. The allocation of consideration between these components is based on their standalone selling prices. However, a practical expedient allows lessees to elect to treat all components (lease and non-lease) as a single lease component if the contract contains a lease and the non-lease components are insignificant or if the practical expedient is applied to a class of similar assets.

For contract hire, if services like maintenance are included, you would typically assess whether these constitute separate performance obligations under IFRS 15. If they do, and if the practical expedient is not applied, the total contract payment would need to be allocated between the lease component (the vehicle use) and the service component (maintenance). The lease component is then accounted for under lease accounting rules.

Practical Expedients and Considerations

The ability to apply practical expedients can simplify accounting. For instance, if maintenance is a significant part of the contract, but the company chooses to apply the practical expedient of not separating lease and non-lease components for a class of similar assets (e.g., all company cars), then the entire contract payment can be treated as a lease payment. This avoids the complex allocation of consideration between the right to use the vehicle and the maintenance service.

Frequently Asked Questions

Q1: Do I need to get a valuation for every contract hired vehicle?
Ideally, yes, to establish the fair value at the commencement of the lease. However, if the contract clearly states the capital value or the initial cash price of the vehicle, this can often be used as a proxy for fair value.

Q2: What if the contract hire payments are not evenly spread?
This is common. The accounting treatment, particularly the effective interest method for the P&L charge, accounts for uneven payments by adjusting the interest and capital portions accordingly each period.

Q3: How do I handle the residual value of the vehicle at the end of the lease?
If there’s a fixed purchase option at the end of the lease, this will influence the residual value used for depreciation. If the vehicle is simply returned, the depreciation should be based on the expected useful life or lease term, aiming to bring the net book value to zero or its expected residual value at that point.

Q4: What if the contract hire agreement includes maintenance and insurance?
As discussed, these are non-lease components. You would either allocate the total consideration based on standalone selling prices or, if eligible and elected, apply the practical expedient to treat the entire contract as a lease.

Q5: Should this always be treated as a finance lease?
If the contract hire agreement transfers substantially all the risks and rewards incidental to ownership of the vehicle, then yes, it should be accounted for as a finance lease under the principles of IAS 17 (or the relevant lease standard applicable at the time, such as IFRS 16 if adopted). Contract hire often falls into this category due to the long-term nature of the commitment and the lack of significant residual interest for the lessor.

Conclusion

Accounting for contract hire vehicles as finance leases requires a systematic approach. By correctly determining the capitalised value, apportioning P&L charges through the effective interest method, managing asset depreciation, and accurately reflecting the lease liability, businesses can ensure compliance and provide a true and fair view of their financial position. Always refer to the specific terms of your contract hire agreements and consult with your accounting professionals to ensure accurate application of accounting standards.