Economic useful life of a leased asset under accounting regulations

This article answers the following questions:

• What regulations help determine whether we are dealing with a finance lease?
• What should be considered when determining the economic useful life of a contract?
• Does the lease term matter when preparing the balance sheet?

Accounting regulations indicate that where a lease agreement has been concluded for a period exceeding ¾ of the expected economic useful life of the leased asset, it is classified as a finance lease and must be recognised in the balance sheet. How can an entrepreneur verify whether a signed contract meets this requirement and should therefore be properly recorded in the accounting records?

Definition of the useful life of the leased asset

Let us begin by defining the key concept – the useful life of the leased asset:

The useful life of a given asset within an enterprise is understood as the period during which it is expected to be used in operating activities (and to generate economic benefits). However, an entrepreneur who recognises a production machine or a delivery vehicle as fixed assets never has absolute certainty as to how long they will remain useful – therefore, determining the useful life is an estimate which (in accordance with the Accounting Act) must be verified at least at the balance sheet date.

An entrepreneur – especially one maintaining full accounting books – should address numerous questions regarding the subject of a lease agreement already at the stage of recognising new assets and determining their useful lives. Article 32(2) of the Accounting Act provides that when determining the economic useful life of a fixed asset, one should consider, among other things:

• the level of use of fixed assets, as well as their efficiency and susceptibility to damage – the useful life will differ for a vehicle used by a sales representative covering tens of thousands of kilometres compared to a vehicle intended for management that travels long distances only occasionally,
• possible renovation costs and estimated expenditure on repairs – both the cost and availability of spare parts should be considered, as well as the level of complexity of potential repairs – these factors are also relevant when estimating useful life,
• the pace of technological change – for certain assets, rapid technological development and the withdrawal of outdated products (and their spare parts) from the market may lead to the need for replacement, which should be included in the analysis,
• legal or other limitations on usage periods – in the case of a lease agreement, the parties define the time framework for the use of assets (which does not mean it cannot be shorter). Therefore, we should also ask: if shorter, by how much? And why exactly by that amount?

How to estimate the useful life of a leased asset?

Entrepreneurs seeking to estimate the useful life of a leased asset may rely on National Accounting Standard No. 5 (NAS 5), specifically section 4.2.3. The standard indicates that when determining this period, one should take into account either the useful life of a comparable asset or the economic useful lives underlying commonly applied depreciation rates.

In the first case, accounting policy will be helpful, as it contains estimated useful lives of leased assets across particular asset categories – provided, of course, that the provisions therein (in particular the depreciation rates) have been properly determined.

In the second case, support comes from the Classification of Fixed Assets register together with Annex No. 1 to the Corporate Income Tax Act. The register enables assigning the leased asset to a specific group of fixed assets, while Annex No. 1 specifies depreciation rates for those groups. 

By combining information from both sources, it is possible to determine, for example, that group 741 (passenger cars) has a depreciation rate of 20%, corresponding to a 5‑year economic useful life.

In addition to Polish accounting regulations (which are not always sufficient to fully address the topic), it is also advisable to refer to International Accounting Standard 16 on “Property, Plant and Equipment”. IAS provides a more precise approach, indicating that the useful life of an asset is defined in terms of the period over which an entity expects the asset to be available for use.

How to verify whether the lease term exceeds the ¾ threshold of economic useful life? 

Let us assume we are faced with the decision of classifying three lease agreements for accounting purposes:

• the first concerns a passenger car – the agreement has been concluded for 4 years and the vehicle is intended for a sales representative,
• the second is also a passenger car lease – likewise concluded for 4 years, but the vehicle is intended for the Finance Director,
• the third concerns a production machine – the lease term is 8 years and the machine is used for metal processing employing an innovative method.

The accounting policy regarding economic useful life specifies the following ranges:

• Transport equipment: 5-7 years,
• Machinery and equipment: 7-10 years.

Example 1 – lease of a car for a sales representative

The starting point for determining economic useful life should be the purpose of the leased asset. A car used by a sales representative may reach as much as 300,000 kilometres after 4 years. Even if it remains operational and can continue to be used, its level of wear will already be significant. 

In such a case, a 5‑year period may be adopted as the lowest reference point within the accounting policy range. A 4‑year lease therefore exceeds the ¾ threshold of economic useful life and should be recognised in the balance sheet as a finance lease (irrespective of whether other criteria are also met – satisfying one condition set out in the Accounting Act is sufficient).

Example 2 – lease of a car for the Finance Director

As in example 1, the intended use of the car plays a key role. Although a lower level of usage is not guaranteed, it is likely to be less intensive than in the case of a sales representative’s vehicle. This allows the assumption that the car will have a longer economic useful life than an identical model used by a sales representative.

In this case, adopting, for example, a 7‑year overall economic useful life would be reasonable. Consequently, the ¾ threshold would not be exceeded, and we would be dealing with an operating lease that is off-balance-sheet (assuming other statutory conditions are not met).

Example 3 – lease of a production machine

The use of the machine for an innovative method in the production process may justify the assumption that, technologically, it will remain useful for many years. If the leased machine is brand new, there may be no need to assume significant renovation expenditure (apart from costs related to planned and natural wear and replacement of minor components). Nevertheless – depending on workload and the number of production cycles – the economic useful life may vary.

Under such assumptions, if the overall useful life is determined to be 10 years, then once again we are dealing with a finance lease – as the machine will be used within the enterprise for more than ¾ of the economic useful life specified in the accounting policy for machinery and equipment.

Classification of a finance lease agreement is crucial for proper balance sheet preparation

As can be seen, lease classification is not as complex as it might seem. Determining the economic useful life should not pose difficulties, provided that each agreement is considered from a broader perspective. 

However, it should be noted that one should not rely solely on standard approaches, as various factors influence the economic useful life. While the examples above may offer guidance by illustrating simplified situations, in some cases the safest solution for an entrepreneur – including those subject to mandatory audit of financial statements – is to seek the assistance of a statutory auditor and develop procedures for handling specific contracts that can be applied in the future. 

For this reason, if you have any questions or doubts regarding the classification of agreements, we invite you to contact our auditors and to follow our knowledge base dedicated to financial and accounting matters.