Lease Accounting. Dr.T.P.Ghosh Professor, MDI, Gurgaon

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1 Lease Accounting Dr.T.P.Ghosh Professor, MDI, Gurgaon

2 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.

3 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.

4 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.

5 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.

6 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.

7 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.

8 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.

9 Valuation problem Suppose, fair value of an asset under finance lease is Rs and the lessee agrees to Rs p.a. His incremental borrowing cost is 10%. Implicit interest rate is 10.42%. See xlsworksheet. Present value of discounted cash flow Rs > Then the lessee should recognise asset and liability at fair value. What if the fair value is Rs 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.

10 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.

11 Para 11 of AS-19 It is deviating from by cash value valuation method while assessing obligation under lease.

12 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.

13 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.

14 Quoting low rate of interest Reduce the profit applying commercial interest rate. Is it going beyond the transaction?

15 Lessee Charges Depreciation Lessee charges depreciation. Should he follow Schedule XIV rate or estimate a different rate which is higher than Schedule XIV?

16 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.

17 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.

18 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.

19 Ceat Ltd 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.

20 Bharti Cellular Ltd 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.