Standard 19: Leases

Standard 19: Leases · Complied AI

(b)

any unguaranteed residual value accruing to the lessor, to be equal to the fair value of the leased asset.

3.18 The lessee’s incremental borrowing rate of interest

is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the

rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar

security, the funds necessary to purchase the asset.

3.19 Contingent rent is that portion of the lease

payments that is not fixed in amount but is based on a factor other than just the passage of time (e.g.,

percentage of sales, amount of usage, price indices, market rates of interest).

4 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. Hire purchase agreements include agreements under which

the property in the asset is to pass to the hirer on the payment of the last instalment and the hirer has a right to

terminate the agreement at any time before the property so passes.

Classification of Leases

5 The classification of leases adopted in this Standard is based on the extent to which risks and rewards incident to

ownership of a leased asset lie with the lessor or the lessee. Risks include the possibilities of losses from idle

capacity or technological obsolescence and of variations in return due to changing economic conditions. Rewards may

be represented by the expectation of profitable operation over the economic life of the asset and of gain from

appreciation in value or realisation of residual value.

6 A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to

ownership. Title may or may not eventually be transferred. A lease is classified as an operating lease if it does

not transfer substantially all the risks and rewards incident to ownership.

7 Since the transaction between a lessor and a lessee is based on a lease agreement common to both parties, it is

appropriate to use consistent definitions. The application of these definitions to the differing circumstances of

the two parties may sometimes result in the same lease being classified differently by the lessor and the lessee.

8 Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than

its form. Examples of situations which would normally lead to a lease being classified as a finance lease are:

(b)

In the above example, suppose the lessor estimates that the

machinery would have a salvage value of Rs. 17,000 on December 31,

20X2. The lessee, however, guarantees a residual value of Rs. 5,000 only.

The interest rate implicit in the lease in this case would remain

unchanged at 16% (approx.). The present value of the minimum lease

payments from the standpoint of the lessee, using this interest rate implicit in

the lease, would be Rs. 2,27,805. As this amount is lower than the fair

value of the leased asset (Rs. 2,35,500), the lessee would recognise the

asset and the liability arising from the lease at Rs. 2,27,805.

In case the interest rate implicit in the lease is not known to the lessee, the

present value of the minimum lease payments from the standpoint of the

lessee would be computed using the lessee's incremental borrowing rate.

12 Transactions and other events are accounted for and presented in accordance with their substance and financial

reality and not merely with their legal form. While the legal form of a lease agreement is that the lessee may

acquire no legal title to the leased asset, in the case of finance

leases the substance and financial reality are that the lessee acquires the economic benefits of the use of

the leased asset for the major part of its economic life in return for entering into an obligation to pay for that

right an amount approximating to the fair value of the asset and the related finance charge.

13 If such lease transactions are not reflected in the lessee’s balance sheet, the economic resources and the

level of obligations of an enterprise are understated thereby distorting financial ratios. It is therefore

appropriate that a finance lease be recognised in the lessee’s balance sheet both as an asset and as an

obligation to pay future lease payments. At the inception of the lease, the asset and the liability for the future

lease payments are recognised in the balance sheet at the same amounts.

14 It is not appropriate to present the liability for a leased asset as a deduction from the leased asset in the

financial statements. The liability for a leased asset should be presented separately in the balance sheet as a

current liability or a long-term liability as the case may be.

15 Initial direct costs are often incurred in connection with specific leasing activities, as in negotiating and

securing leasing arrangements. The costs identified as directly attributable to activities performed by the lessee

for a finance lease are included as part of the amount recognised as an asset under the lease.

16 Lease payments should be apportioned between the finance charge and the reduction of the outstanding

liability. The finance charge should be allocated to periods during the lease term so as to produce a constant

periodic rate of interest on the remaining balance of the liability for each period.

Example

In the example (a)

illustrating paragraph 11, the lease payments would be apportioned by the lessee between the finance

charge and the reduction of the outstanding liability as follows:

Year

Finance

charge

(Rs.)

Payment (Rs.)

Reduction

outstanding liability (Rs.)

Outstanding

liability (Rs.)

Year 1

(January

2,35,500

(December 31)

37,680

1,00,000

62,320

1,73,180

Year 2

(December

31)

27,709

1,00,000

72,291

1,00,889

Year 3

(December

31)

16,142

1,00,000

83,858

17,031

* The difference between

this figure and guaranteed residual value (Rs.17,000) is due to

approximation in computing the interest rate

implicit in the lease.

17 In practice, in allocating the finance charge to periods during the lease term, some form of approximation may be

used to simplify the calculation.

18 A finance lease gives rise to a depreciation expense for the asset as well as a finance expense for

each accounting period. The depreciation policy for a leased asset should be consistent with that for depreciable

assets which are owned, and the depreciation recognised should be calculated on the basis set out in Accounting Standard (AS) 10, Property, Plant

and Equipment . If there is no reasonable certainty that the lessee will obtain ownership by the end of the

lease term, the asset should be fully depreciated over the lease term or its useful life, whichever is shorter.

19 The depreciable amount of a leased asset is allocated to each accounting period during the period of expected use

on a systematic basis consistent with the depreciation policy the lessee adopts for depreciable assets that are

owned. If there is reasonable certainty that the lessee will obtain ownership by the end of the lease term, the

period of expected use is the useful life of the asset; otherwise the asset is depreciated over the lease term or

its useful life, whichever is shorter.

20 The sum of the depreciation expense for the asset and the finance expense for the period is rarely the same as the

lease payments payable for the period, and it is, therefore, inappropriate simply to recognise the lease payments

payable as an expense in the statement of profit and loss. Accordingly, the asset and the related liability are

unlikely to be equal in amount after the inception of the lease.

21 To determine whether a leased asset has become impaired, an enterprise applies the Accounting Standard (AS) 28, Impairment of Assets , that

sets out the requirements as to how an enterprise should perform the review of the carrying amount of an asset, how

it should determine the recoverable amount of an asset and when it should recognise, or reverse, an impairment loss.

22 The lessee should, in addition to the requirements of AS 10, Property, Plant and Equipment, and the

governing statute, make the following disclosures for finance leases:

(e)

a general description of the lessee’s significant leasing arrangements including, but not limited to,

the following:

(i)

the basis on which contingent rent payments are determined;

(ii)

the existence and terms of renewal or purchase options and escalation clauses; and

(iii)

restrictions imposed by lease arrangements, such as those

concerning dividends, additional debt, and further leasing.

Proviso

Provided that a Small and Medium Sized Company and a Micro, Small

and Medium Sized non-company entity, as defined in Appendix I to this

Compendium, may not comply with sub-paragraphs (a), (b) and (e).

Leases in the Financial Statements of Lessors

Finance Leases

26 The lessor should recognise assets given under a finance lease in its balance sheet as a receivable

at an amount equal to the net investment in the lease.

27 Under a finance lease substantially all the risks and rewards incident to legal ownership are transferred by the

lessor, and thus the lease payment receivable is treated by the lessor as repayment of principal, i.e., net

investment in the lease, and finance income to reimburse and reward the lessor for its investment and services.

28 The recognition of finance income should be based on a pattern reflecting a constant periodic rate

of return on the net investment of the lessor outstanding in respect of the finance lease.

29 A lessor aims to allocate finance income over the lease term on a systematic and rational basis. This income

allocation is based on a pattern reflecting a constant periodic return on the net investment of the lessor

outstanding in respect of the finance lease. Lease payments relating to the accounting period, excluding costs for

services, are reduced from both the principal and the unearned finance income.

30 Estimated unguaranteed residual values used in computing the

lessor’s gross investment in a lease are reviewed regularly. If there has been a reduction in the estimated

unguaranteed residual value, the income allocation over the remaining lease term is revised and any reduction in

respect of amounts already accrued is recognised immediately. An upward adjustment of the estimated residual value

is not made .

31 Initial direct costs, such as commissions and legal fees, are often incurred by lessors in negotiating and

arranging a lease. For finance leases, these initial direct costs are incurred to produce finance income and are

either recognised immediately in the statement of profit and loss or allocated against the finance income over the

lease term.

32 The manufacturer or dealer lessor should recognise the transaction of sale in the statement of

profit and loss for the period, in accordance with the policy followed by the enterprise for outright sales. If

artificially low rates of interest are quoted, profit on sale should be restricted to that which would apply if a

commercial rate of interest were charged. Initial direct costs should be recognised as an expense in the statement

of profit and loss at the inception of the lease.

33 Manufacturers or dealers may offer to customers the choice of either buying or leasing an asset. A finance lease

of an asset by a manufacturer or dealer lessor gives rise to two types of income:

(a)

and (f). Further, a Micro, Small and Medium Sized non-company entity as defined in

Appendix 1 to this Compendium, may not comply with sub-paragraphs (a), (f) and (g).

38 As an indicator of growth it is often useful to also disclose the gross investment less unearned income in new

business added during the accounting period, after deducting the relevant amounts for cancelled leases.

Proviso

Provided that a Micro, Small and Medium Sized non-company entity, as defined in Appendix 1 to this

Compendium, may not comply with disclosure requirement of paragraph 38.

Operating Leases

39 The lessor should present an asset given under operating lease in its balance sheet under fixed

assets.

40 Lease income from operating leases should be recognised in the statement of profit and loss on a

straight line basis over the lease term, unless another systematic basis is more representative of the time pattern

in which benefit derived from the use of the leased asset is diminished.

41 Costs, including depreciation, incurred in earning the lease income are recognised as an expense. Lease income

(excluding receipts for services provided such as insurance and maintenance) is recognised in the statement of

profit and loss on a straight line basis over the lease term even if the receipts are not on such a basis, unless

another systematic basis is more representative of the time pattern in which benefit derived from the use of the

leased asset is diminished.

42 Initial direct costs incurred specifically to earn revenues from an operating lease are either deferred and

allocated to income over the lease term in proportion to the

recognition of rent income, or are recognised as an expense in the statement of profit and loss in the period in

which they are incurred.

43 The depreciation of leased assets should be on a basis consistent with the normal depreciation

policy of the lessor for similar assets, and the depreciation charge should be calculated on the basis set out in AS

10, Property, Plant and Equipment.

44 To determine whether a leased asset has become impaired, an enterprise applies AS 28, Impairment of Assets , that sets out the

requirements for how an enterprise should perform the review of the carrying amount of an asset, how it should

determine the recoverable amount of an asset and when it should recognise, or reverse, an impairment loss.

45 A manufacturer or dealer lessor does not recognise any selling profit on entering into an operating lease because

it is not the equivalent of a sale.

46 The lessor should, in addition to the requirements of and AS 10, Property, Plant and Equipment, and

the governing statute, make the following disclosures for operating leases:

(e)

accounting policy adopted in respect of initial direct costs.

Proviso

Provided that a Small and Medium Sized Company as defined in Appendix 1

to this Compendium, may not comply with

subparagraphs (b) and (d). Further, a Micro, Small and Medium Sized non-company

entity, as defined in Appendix 1 to this Compendium, may not comply with sub-paragraphs (b), (d) and (e) .

Sale and Leaseback Transactions

47 A sale and leaseback transaction involves the sale of an asset by the vendor and the

leasing of the same asset back to the vendor. The lease payments and the sale price are usually interdependent

as they are negotiated as a package. The accounting treatment of a sale and leaseback transaction depends upon

the type of lease involved.

48 If a sale and leaseback transaction results in a finance lease, any excess or deficiency of sales

proceeds over the carrying amount should not be immediately recognised 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.

49 If the leaseback is a finance lease, it is not appropriate to regard an excess of sales proceeds over the carrying

amount as income. Such excess is deferred and amortised over the lease term in proportion to the depreciation of the

leased asset. Similarly, it is not appropriate to regard a deficiency as loss. Such deficiency is deferred and

amortised over the lease term.

50 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.

51 If the leaseback is an operating lease, and the lease payments and the sale price are established at fair value,

there has in effect been a normal sale transaction and any profit or loss is recognised immediately.

52 For operating leases, if the fair value at the time of a sale and leaseback transaction is less than

the carrying amount of the asset, a loss equal to the amount of the difference between the carrying amount and fair

value should be recognised immediately.

53 For finance leases, no such adjustment is necessary unless there has been an impairment in value, in which case

the carrying amount is reduced to recoverable amount in accordance with the Accounting Standard dealing with

impairment of assets.

54 Disclosure requirements for lessees and lessors apply equally to sale and leaseback transactions. The required

description of the significant leasing arrangements leads to disclosure of unique or unusual provisions of the

agreement or terms of the sale and leaseback transactions.

55 Sale and leaseback transactions may meet the separate disclosure criteria set out in paragraph 12 of Accounting Standard (AS) 5 , Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting

Policies .

Illustration

Sale and Leaseback Transactions that Result in Operating Leases

The illustration does not form part of the accounting standard. Its purpose is to illustrate the

application of the accounting standard.

A sale and leaseback transaction that results in an operating lease may give rise to profit or a loss, the

determination and treatment of which depends on the leased asset’s carrying amount, fair value and selling

price. The following table shows the requirements of the accounting standard in various circumstances.

Sale price established at

fair value (paragraph 50)

Carrying amount equal to

fair value

Carrying amount less than

fair value

Carrying amount above fair

value

Profit

No profit

Recognise profit

immediately

Not applicable

Loss

No loss

Not applicable

Recognise loss

immediately

Sale price below

fair value (paragraph 50)

Profit

No profit

Recognise profit

immediately

profit (note 1)

Loss not

compensated by future lease

payments at below market

Recognise

loss immediately

Recognise loss

immediately

(note 1)

Loss

compensated by future

lease payments at

Defer and

amortise loss

Defer and amortise

loss

(note 1)

Sale price above

fair value (paragraph 50)

Profit

Defer

and amortise profit

Defer and

amortise profit

Defer and amortise profit

(note 2)

Loss

No loss

(note 1)

Note 1. These parts of the table represent circumstances that would have been dealt

with under paragraph 52 of the Standard. Paragraph 52 requires the carrying amount of an asset to be written

down to fair value where it is subject to a sale and leaseback.

Note 2. The profit would be the difference between fair value and sale price as the

carrying amount would have been written down to fair value in accordance with paragraph 52.

Footnotes

* The Standard was earlier notified as part of Companies

(Accounting Standards) Rules, 2006, under Companies Act, 1956. The Standard has been notified as part of Companies

(Accounting Standards) Rules, 2021, under Companies Act, 2013. The following footnote has been inserted in Companies

(Accounting Standards) Rules, 2021, which is relevant for companies: