Lease Accounting
Dr.T.P.Ghosh
Professor , MDI , Gurgaon
Controversy Over Lease
Classification and Accounting
• The basic concept of lease accounting is that some leases are
merely rentals, whereas others are disguised purchases. For
instance, if you rent office space for a year, the space is worth nearly
as much at the end of the year as when you started; you are simply
using it for a short period of time. This rental is called an operating
lease.
• If you lease a computer for five years, however, at the end of the
lease the computer is nearly worthless. The lessor (the person who
receives the rents) anticipates this, and charges the lessee (the
person who uses the asset) a rent that will recover all of the lease's
costs, with a profit built in. This is essentially a purchase with a loan,
which is called a capital lease or finance lease , and an asset and
liability must be set up on the lessee's primary financial statements.
Rental payments are considered repayments of the loan;
depreciation and interest expense, rather than rent expense, are
shown on the income statement.
Meaning
• A finance lease is a lease that transfers
substantially all the risks and rewards
incident to ownership of an asset.
Title may or may not eventually be
transferred.
This is based on the concept of substance
over form.
• An operating lease is a lease other than a
finance lease.
Symptoms when a lease should
classified as finance lease
•
Transfer of ownership at the end of lease term
•
Purchase option to the lessee at a price which is expected to be sufficiently lower
than the fair value at the date the option becomes exercisable such that, at the
inception of the lease, it is reasonably certain that the option will be exercised;
•
The lease term is for the major part of the economic life of the asset even if title is not
transferred;
•
At the inception of the lease the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset; and
•
The leased asset is of a specialised nature such that only the lessee can use it
without major modifications being made.
Other symptoms
•
If the lessee can cancel the lease, the lessor’s losses
associated with the cancellation are borne by the
lessee;
•
Gains or losses from the fluctuation in the fair value of
the residual fall to the lessee (for example in the form
of a rent rebate equalling most of the sales proceeds
at the end of the lease); and
•
The lessee can continue the lease for a secondary
period at a rent which is substantially lower than
market rent.
Certain Important Terms
•
•
Inception of lease : Earlier of the date of the lease agreement and
the date of a commitment by the parties to the principal provisions
of the lease.
Non-cancellable lease :Conditional cancellation (i) upon the occurrence of some remote contingency; or
(ii) with the permission of the lessor; or
(iii) if the lessee enters into a new lease for the same or an
equivalent asset with the same lessor; or
(iv) upon payment by the lessee of an additional amount such that,
at inception, continuation of the lease is reasonably certain.
Certain Important Terms
Minimum lease payments
• Payments over the lease term that the lessee is, or can be
required, to make excluding contingent rent, costs for services
and taxes to be paid by and reimbursed to the lessor, together
with ( in the case of the lessee ) any residual value guaranteed
by or on behalf of the lessee.
• Payments over the lease term that the lessee is, or can be
required, to make excluding contingent rent, costs for services
and taxes to be paid by and reimbursed to the lessor, together
with ( in the case of the lesPayments over the lease term that
the lessee is, or can be required, to make excluding contingent
rent, costs for services and taxes to be paid by and reimbursed
to the lessor, together with ( in the case of the lessor ) any
residual value guaranteed by or on behalf of the lessee or
by an independent third party.
Finance Lease Valuation
• Lessee recognises asset and liability
arising out of finance lease transaction
applying implicit interest rate / incremental
borrowing cost as discount factor
• Obligation under lease is simply finance
lease payables.
Valuation problem
• Suppose , fair value of an asset under finance lease is
Rs. 775000 and the lessee agrees to pay @ Rs. 200000
p.a . His incremental borrowing cost is 10%. Implicit
interest rate is 10.42% . See xlsworksheet.
• Present value of discounted cash flow Rs.758157 >
750000 . Then the lessee should recognise asset and
liability at fair value.
• What if the fair value is Rs. 750000. Then the lessee
should account for the obligation at a higher amount. But
the leasehold asset should be recognised at fair value.
The lessee should then recognised loss at the inception
of the transaction.
Para 11 of AS-19
• At the inception of a finance lease, the lessee should recognise
the lease as an asset and a liability. Such recognition should be
at an amount equal to the fair value of the leased asset at the
inception of the lease.
• However, if the fair value of the leased asset exceeds the
present value of the minimum lease payments from the
standpoint of the lessee, the amount recorded as an asset and
a liability should be the present value of the minimum lease
payments from the standpoint of the lessee.
• In calculating the present value of the minimum lease payments
the discount rate is the interest rate implicit in the lease, if this
is practicable to determine; if not, the lessee’s incremental
borrowing rate should be used.
Para 11 of AS-19
• It is deviating from by cash value
valuation method while assessing
obligation under lease .
Valuation Using IRR
• IRR is 10.42%
• Lease payments are classified into finance
charge and principal repayment.
• At this stage also if the interest rate
changes obligation is not made mark to
market.
Manufacturer Lessor
• Distinguish between profit arising out of
outright sale and finance charge. Profit
airising out of outright sale should be
recognised at the inception of lease.
Quoting low rate of interest
• Reduce the profit applying commercial
interest rate.
• Is it going beyond the transaction ?
Lessee Charges Depreciation
• Lessee charges depreciation . Should he
follow Schedule XIV rate or estimate a
different rate which is higher than
Schedule XIV ?
Lessor’s Receivable
• It is present value of future cash flow. If
that is so what should the be the discount
factor? Current asset should be booked at
fair value which is can be arrived only if
latest incremental lending rate is used.
Sale and lease bacK : Finance
Lease Type
• Do not recognise any excess or
deficiency of sales proceeds over the
carrying amount immediately as as
income or loss in the financial
statements of a seller-lessee.
• Instead, it should be deferred and
amortised over the lease term in
proportion to the depreciation of the
leased asset.
Sale and lease bacK : Operating
Lease Type
• If a sale and leaseback transaction results in an
operating lease, and it is clear that the transaction is
established at fair value, any profit or loss should be
recognised immediately.
• If the sale price is below fair value, any profit or loss
should be recognised immediately except that, if the
loss is compensated by future lease payments at
below market price, it should be deferred and
amortised in proportion to the lease payments over
the period for which the asset is expected to be
used.
• If the sale price is above fair value, the excess over
fair value should be deferred and amortised over the
period for which the asset is expected to be used.
Ceat Ltd. 2002-03
J) Lease Rentals :
Assets acquired prior to 1st April, 2001 under Finance Leases were being
accounted by segregating the lease rentals into cost component and
interest component by applying an implicit rate of return. The cost
component was being amortized over the useful life of the asset, the
interest component was charged as a period cost and the aggregate was
debited to the profit and loss account under the head 'Lease Rent'.
The lease payment in excess of or lower than the charge for the year were
being carried as prepaid sums or liabilities respectively. During the year, the
Company has changed this policy. The cost component, which was
amortized and the amount representing prepaid sum related thereto have
being shown as Additions under the head 'Lease Assets' in Fixed Assets.
The cost component which was amortized in the past has been shown as
Adjustment to Depreciation in the Fixed Assets. This change has no impact
on the Profit and Loss Account.
Secondary Lease rentals are being charged to Profit and Loss Account.
Bharti Cellular Ltd.
2002-03
• Lease Rentals in respect of assets taken on
'Operating Lease' are charged to the Profit and
Loss Account.
• Assets taken on Finance Lease are accounted
for as assets of the Company. Lease rentals
payable are apportioned between principal and
interest using the internal rate of return method
and finance charge is recognised accordingly.