Accounting Standard (AS) 19: Leases
Lease is an arrangement by which the “Lessor” gives the right to use an asset for given period of time to the “Lessee” on rent.
It involves two parties, a Lessor and a Lessee and an asset which is to be leased. The Lessor, who owns the asset, agrees to allow to the Lessee to use it for a specified period of time in return for periodic rent payments.
Types of lease
It is a lease, which transfers substantially all the risks and rewards incidental to ownership of an asset to the Lessee by the Lessor but not the legal ownership. In following situations, the lease transactions are called Finance Lease:
- The lessee will get the ownership of leased asset at the end of the lease term.
- The lessee has an option to buy the leased asset at the end of term at price, which is lower than its expected fair value at the date on which option will be exercised.
- The lease term covers the major part of the life of asset.
- At the beginning of lease term, present value of minimum lease rental covers substantially the initial fair value of the leased asset.
- The asset given on lease to lessee is of specialized nature and can only be used by the lessee without major modification.
It is a lease which does not transfer substantially all the risk and reward incidental to ownership.
Classification of lease is made at the inception of the lease; if at any time the Lessee and Lessor agree to change the provision of lease and it results in different category of lease, it will be treated as separate agreement.
The Accounting Standard is not applicable to following types of lease:
- Lease agreement to explore natural resources such as oil, gas, timber, metal and other mineral rights.
- Licensing agreements for motion picture film, video recording, plays, manuscripts, patents and other rights.
- Lease agreement to use land.
Guaranteed Residual value – (G.R.V.)
- In respect of Lessee: Such part of the residual value (R.V.), which is guarantee by or on behalf of the lessee.
- In respect of Lessor: Such part of the residual value, which is guaranteed by or on behalf of the lessee or by an independent third party.
For the Lessor the residual value guaranteed by the third party can arise when the asset is leased to the third party after the first lease has expired and therefore it can be called the residual value guaranteed by the third party to the Lessor.
Unguaranteed Residual Value (U.R.V)
The difference between residual value of asset and its guaranteed residual value is unguaranteed residual value. [R.V- G.R.V.]
Gross Investment (MLP+URV)
Gross investment in lease is the sum of the following:
- Minimum lease payment (from the standpoint of Lessor) and
- Any unguaranteed residual value accruing to the Lessor.
Interest rate implicit in the lease
When the Lessor gives an asset on lease (particularly on finance lease), the total amount, which he receives over lease period by giving the asset on lease, includes the element of interest plus payment of principal amount of asset. The rate at which the interest amount is calculated can be simply called implicit rate of interest. It can be expressed as under:-
It is the discount rate at which Fair Value of leased Asset (At the inception of lease) = = Present value of [Minimum lease payment (in respect of Lessor)]+ Any unguaranteed residual value accruing to the Lessor.
Lease Rent fixed on the basis of percentage of sales, amount of usage, price indices, market rate of interest is called contingent rent. In other words, lease rent is not fixed, but it is based on a factor other than time.
Minimum lease payments [MLP]
- For Lessor = Total lease rent to be paid by lessee over the lease terms + any guaranteed residual value (by or on behalf of lessee) – contingent Rent – cost for service and tax to be paid by the reimbursed to Lessor + residual value guaranteed by third party.
- For Lessee = Total lease rent to be paid by lessee over the lease terms + any guaranteed residual value (for lessee) – contingent rent – cost for service and tax to be paid by and reimbursed to Lessor.
Lease includes Hire Purchase
The definition of a ‘lease’ includes agreements for the hire of an asset, which contain a provision giving the hirer an option to acquire title to the asset upon the fulfillment of agreed conditions. These agreements are commonly known as hire purchase agreements.
Accounting for Finance Lease
In the books of Lessee
- Leased asset as well as liability for lease should be recognized at the lower of –
- Fair value of the leased asset at he inception of lease or
- Present value of minimum lease payment from the lessee point of view.
- Apportionment of lease payment-Each lease payment is apportioned between finance charge and principal amount.
- The lessee in its books should charge depreciation on finance lease asset as per AS-6(in this case, straight line method will be followed)
- Initial direct cost for financial lease is included is asset under lease.
In the books of Lessor
- The Lessor should recognize asset given under finance lease as receivable at an amount equal to net investment in the lease and corresponding credit to sale of asset.
Net Investment = Gross Investment – Unearned Finance Income.
Gross Investment = Minimum lease payment from Lessor point of view + Unguaranteed residual value.
Unearned Finance Income=Gross Investment – Present Value of Gross Investment.
- Recognition of Finance Income
The Lessor should recognize the finance income based on a pattern reflecting, constant periodic return on the net investment outstanding in respect of the finance lease. In simple words interest / finance income will be recognized in proportion to outstanding balance receivable from lease over lease period.
Accounting for Operating Lease
In the books of Lessor
- Record leased out asset as the fixed asset in the balance sheet.
- Charge depreciation as per AS-6
- Recognize lease income in profit & loss account using straight line method. If any other method reflects more systematic allocation of earning derived from the diminishing value of leased out asset, that approach can be adopted.
- Other costs of operating lease should be recognized as expenses in the year in which they are incurred.
- Initial direct cost of the lease may be expensed immediately or deferred.
In the Books of Lessee
Lease payments should be recognized as an expense in the profit and loss account on a straight line basis over the lease term. If any other method is more representative of the time pattern of the user’s benefit, such method can be used.
Sale and Lease Back
A sale and lease back transaction involves the sale of an asset by vendor and leasing of the same asset back to the vendor.
Accounting treatment of Sale and Lease back
If lease back is Finance Lease
- Any profit or loss of sale proceeds over the carrying amount should not be immediately recognized as profit or loss in the financial statements of a seller-lessee.
- It should be deferred and amortized over lease term in proportion to the depreciation of leased asset.
If lease back is Operating Lease
Any profit or loss arising out of sale transaction is recognized immediately when sale price is equal to fair value
(A) If Sale price” below” fair value
- Profit – i.e. carrying amount (=book value or value as per balance sheet) is less than the sale value, recognize profit immediately.
- Loss – i.e. carrying amount is more than the sale value, recognize loss immediately, provided loss is not compensated by future lease payment.
- Loss – i.e. carrying amount is more than sale price defer and amortize loss if loss is compensated by future lease payment.
(B) If Sale price “above” fair value
- If carrying amount is equal to fair value which will result in profit, amortize the profit over lease period.
- Carrying amount less than fair value will result in profit – amortize and defer the profit equal to “sale price less fair value” and recognize balance profit immediately.
- Carrying amount is more than the fair value – which will result in loss equal to – (carrying amount less than fair value), should be recognized immediately. Profit equal to – selling price less fair value –should be amortized.