LEASES ACCOUNTING STANDARD (AS) 19

LEASE AGREEMENT: Lease agreement is a contract between two parties, the lessor and the lessee. the lessor is the legal owner of the assets, and…… The lessee obtains the right to use that asset in return for rental payments.

This was known as “ off balance sheet” finance. Historically, Assets that were used but not owned were not shown in the statement of financial position and therefore any associated liability was also left out of the balance sheet. This was known as “ off balance sheet” finance.

Under modern accounting, The IASB framework states that an asset is a resource controlled by an entity as result of past events and from which future economic benefits are expected to flow to the entity’. A liability is a present obligation of the entity arising from the past events, the settlement of which is expected to result in an outflow from the entity of resources.

Accounting Standard (AS) 19, ‘Leases’, was issued by the council of the Institute of Chartered Accountants of India, which came into effect in respect of all assets leased during accounting periods commencing on or after 1.4.2001 and is mandatory from that date.

OBJECTIVE: The objective is to prescribe, for lessor and the lessee, the appropriate accounting policies and…. Disclosures in relation to financial and operating leases.

Scope/ Applicability Does not apply to: Leases agreement for natural resources such as oil, gas, timber, metals etc. Licensing agreements for items such as motion picture films, video recordings, plays, manuscripts, patents and copyrights. Lease agreements to use lands.

Terminology : Lease agreement. Financial lease: is a lease that transfers substantially all the risks and rewards incidental to ownership of an assets. operating lease: is a lease other than a financial lease.

A non cancellable lease is a lease that is cancellable only: On the occurrence of some remote contingency; or With the permission of lessor. The inception the lease of is the earlier of the date of the lease agreement and the date of commitment by the parties. The lease term is the non cancellable period for which the lessee has agreed to take asset on lease

Minimum lease payments (MLP): FROM THE STANDPOINT OF LESSEE: Minimum rent- residual value guaranteed by or on behalf of lessee. FROM THE STANDPOINT OF LESSOR: minimum rent- residual value guaranteed by or on behalf of the lessee or by an independent party.

Fair value: is the amount for which an asset could be exchanged or a liability is settled between the parties in the agreement. Useful life of a leased asset is either: -the period over which the leased asset is expected to be used by the lessee. -the number of production or similar units expected to be obtained from the use of the asset. Residual value of asset is the estimated fair value of the asset at the end of the lease term.

Guaranteed value is: In the case of lessee, that part of residual value which is guaranteed by the lessee or by a party on behalf of the lessee. In case of lessor, that part of the residual value which is guaranteed by or on behalf of the lessee, or by an independent third party.

Unguaranteed residual value: is the amount by which the residual value exceeds its guaranteed residual value. Gross investment= MLP from the standpoint of the lessor – unguaranteed residual value. Unearned finance income= gross investment in the lease – net investment in the lease. Net investment = gross investment – unearned finance income.

Interest rate implicit: It is a discount rate which equates gross investment in the lease to the fair value. Contingent rent: It is that portion of the lease payments that is not fixed in amount but is based on production or rendering services E.g. percentage of sales.

CLASSIFICATION OF LEASE FINANCE LEASE OPERATING LEASE If substantially all the risks and rewards incident to ownership. The Title may or may not eventually be transferred. If it does not transfer substantially all the risks and rewards incident to ownership.

Examples of Situations which would normally lead to a lease classified as a finance lease are : The lease transfers ownership of the asset to the lessee by the end of the lease term The lessee has the option to purchase the asset The lease term is for the major part of the economic life of the asset 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 asset. The leased asset is of a specialized nature such that only lessee can use it without major modification.

Treatment of Finance Lease in the books of Lessee At the inception, Lease should be recognized as an asset and a liability. Initial Accounting – Non current assets Dr. To Finance lease liability (lower fair value of the asset or the present value of the minimum lease payments)

Subsequent Accounting DEPRECIATION Depreciation expense Dr. To Accumulated depreciation LEASE RENTAL / INTEREST for example, a company could buy an asset with the economic life 4 years for Rs.10,000 or lease it for paying a rental of Rs.3000 p.a.

DISCLOSURE Assets acquired are segregated from the assets owned For each class of asset, the net carrying amount at the balance sheet date A reconciliation between the total of minimum lease payments at the balance sheet date and their present value. Contingent rents recognized as expense in the statement of profit and loss for the period

The total of future minimum sublease payments expected to be received under non-cancellable subleases at the balance sheet date. A general description of the lessee’s significant leasing arrangements. Basis for contingent rent payments Existence and terms of renewal or purchase options and escalation clauses Restrictions imposed by lease arrangements, such as concerning dividends, additional debt, further leasing.

EXAMPLE : On 1 April 2009 Bush Co entered into an agreement to lease a machine that had an estimated life of 4 yrs. The lease period is also 4 years, at which point asset will be returned to the leasing company. Annual rentals of Rs.5000 are payable in arrears from 31 March 2010. The machine is expected to have a nil Residual Value at the end of its life. Machine had a fair rental value of Rs.14,275 at the inception of the lease. The lessor includes a finance cost of 15% p.a. when calculating annual rentals

INITIAL ACCOUNTING : Recognise the asset and the lease liability How should the lease be accounted for in the financial statements of Bush for the year end 31 March 2010 ? SOLUTION : INITIAL ACCOUNTING : Recognise the asset and the lease liability Dr. Property , plant and equipment 14,275 Cr. To Finance lease obligation

SUBSEQUENT ACCOUNTING : Depreciation Dr. Depreciation expense (14,275/4 years ) 3,568 Cr. Accumulated depreciation

SUBSEQUENT ACCOUNTING : Lease rental/ interest YEAR (i) B/Fwd (ii) INTEREST (15%) (iii) RENTAL (iv) C/Fwd = ( ii + iii + iv ) 1 14,275 2,141 (5000) 11,416 2 1,712 8,128

STATEMENT OF PROFIT OR LOSS EXTRACT Depreciation 3,568 Finance costs 2,141

STATEMENT OF FINANCIAL POSITION EXTRACT Non – current assets : Carrying value machine (14,275 – 3,568) 10,707 Non – current liabilities : Lease obligation 8,128 Current liabilities Capital (11,416 – 8,128) 3,288

2. TREATMENT IN CASE OF FINANCE LEASE IN THE BOOKS OF LESSOR Substantially all the risk and rewards incident to legal ownership are transferred by the lessor Lease payment receivable by the lessor is treated as repayment of principal i.e. Net investment in the lease and finance income to reimburse and reward the lessor

Lease payments relating to the period, are reduced from both the principal and unearned finance income Initial direct costs are either recognised immediately in the STATEMENT OF PROFIT AND LOSS or ALLOCATED AGAINST FINANCE INCOME over the lease term

DISCLOSURE A reconciliation between the Total Gross Investment in the lease , and the present value of Minimum Lease Payments receivables at the balance sheet date Unearned finance income The unguaranteed residual values accruing to benefit of the lessor The accumulated provision for uncollectible minimum lease payments receivable

e) Contingent rents recognised in the Statement of Profit and Loss f) General description of the significant leasing arrangements of the lessor g) Accounting policy adopted in respect of initial direct cost h) Small and Medium Companies, may not comply with above requirements

3. Treatment in case of operating lease in the book of lessee an asset is not recognized in the statement of financial position. Rentals are charged to the statement of profit or loss on straight line basis over the term of the lease. Any difference between amounts charged and paid will be prepayments or accruals. Costs including depreciation incurred in earning the lease income are recognized as an expense. Initial direct cost are either deferred over lease term or recognized as expense

DISCLOSURES The total of future minimum lease payments under non- cancellable operating lease for each of the following periods: Not later than 1 year Later than 1 year but not later than 5 years Later than five years b) the minimum sublease payments expected to be received under non-cancellable sublease at the balance sheet date c) lease payments recognized in the statement of profit and loss with separate amount of minimum lease payments and contingent rents

d) sub-lease payments received recognized in the statement of profit and loss for the period e) Description of the lessee’s significant leasing arrangements including, but not limited to the following: The basis on which contingent rent payment are determined The existence and terms of renewal or purchase options and escalation clauses Restrictions imposed by lease arrangements

Example- on 1 October 2000 Alpine Ltd entered into an agreement to lease a machine that had an estimated life of 10 years. The lease period is for 4 years with annual rentals of 5000 payable in advance from 1 October 2009. the machine is expected to have a nil residual value at the end of its life. The machine had a fair value of 50000 at the inception of the lease. how should the lease be accounted for in the financial statement of Alpine for the year end 31 March 2010

Solution - Rentals of rs. 5000 paid on 1 October This rental cover the lease period 1-10-2009 to 30-09-2010 and therefore 2500 ( last 6 months’ rental ) has been prepaid Dr. Lease expense ( statement of profit or loss) 5,000 Cr. Bank 5,ooo

Dr. prepayments 2500 Cr. Lease expense Lease expense Current assets : Statement of profit or loss extract Lease expense Statement of financial position extract Current assets : Prepayments

4. Treatment in case of operating lease in the book of lessor Lessor should present asset under fixed assets Lease income should be recognized on a straight line basis or other systematic basis Depreciation should be recognized as an expense initial direct costs are either deferred over lease term or recognized as expense

Disclosure- Carrying amount of leased assets Accumulated depreciation and impairment loss Future minimum lease payments in aggregate and for the specified periods General description of the leasing arrangement and policy for initial costs.

5. Sales and leaseback transactions 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 accounting treatment of transaction depend upon type of lease involved: If sale and leaseback transaction results in a finance lease- any excess or deficiency of sales proceeds over the carrying amount should not be immediately recognized as income or loss in financial statement. It should be deferred and amortized over the lease term in proportion to the depreciation of the leased assets.

b. If a sale and leaseback transaction results in a operating lease- If the lease payments and the sale price are established at fair value, there will be a normal sale transaction and any profit or loss is recognized immediately. If fair value is less than the carrying amount of asset, a loss equal to the difference between the carrying amount and fair value should be recognized immediately.

Disclosure – The disclosure of unique or unusual provision of the agreement or terms of the sale and leaseback transactions. Sales and leaseback transaction may meet the separate disclosure criteria set out in AS 5 , net profit or loss for the period, prior period items and changes in accounting policies.

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