Types of Leases and its Disclosure in Financial Statements

CS Deepak Pratap Singh

Lease: is defined as a lease is an arrangement whereby the lessor conveys to lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

In an agreement of Lease the Lessor and the Lessee enter into an arrangement in which lessor transfer right to use an asset to Lessee against a payment of Lease Rental for a period of time. In some cases if mentioned in the agreement or according to terms and conditions of the lease, Lessee has right to acquired ownership of the asset leased at the end of lease period.

A Hire Purchase agreement is also considered as Lease Agreement.

The Accounting standard No. 19 is promulgated to provide accounting policies to be followed by the lessors and lessees, in lease transaction and relevant disclosures have been made in the Financial Statements.

Lessor

Transfers right to use asset ———————————————— > <————————————————- Payments for right to use asset

Lessee

TYPES OF LEASES:

Finance Lease	Operating Lease
[Transfers substantially all the Risks and rewards incidental to ownership of an asset]	[A lease other than     Financial Lease (i.e. dose not transfer of substantial risk and rewards linked with ownership)]

DEFINATION OF SOME TERMS;

FINANCE LEASE; main ingredient are

1. A lease in which the ownership of lease assets will be transferred to the lessee at the end of lease period (provided that this clause has been incorporated in the Lease Agreement at the time of inception or after amendments if any).

2. The lessee has option to purchase the leased asset at a price, which will be much lower than the fair price of the asset, at the end of period of lease or as provided in the lease agreement.

3. The term of lease will cover major part of economic value of the assets lease even though the title of ownership will not transferred to the lessee till the exercise of option of purchase of asset.

4. The MLP as determined at the inception of the lease generally covered at least substantially all of fair value of the leased asset.

5. The leased asset is of a specialized nature such that only lessee can use the in its business.

6. A lease if finance lease if according to terms of lease , it is provided that if lessee cancels the lease then all consequences relating to lease or loss will be borne by the lessee.

Inception of Lease; is from the earlier of

1. Date of lease agreement or

2. Date of a commitment by the parties to the principal provisions of the lease.

Lease Term; Non cancellable period for which;

1. The lessee has agreed to take assets at lease and any further period for which lessee has agreed to use the asset of the lease will be added in the term of lease.

Minimum Lease Payments; The payments which have to be made by lessee over term of lease as agreed in the Lease Agreement and added any residue value as guaranteed or agreed by the lessee at the inception of the lease.

Minimum Lease Premium= Lease Payment over lease terms + Residual Value guaranteed by or on behalf of lessee.

Gross Investment Value; Aggregate of MLPs under a Finance Lease from lessor’s perspective (+) Unguaranteed Residual Value accruing to the lessor.

Gross Investment Value= Minimum Lease Premium under a Finance Lease + Unguaranteed residual value.

Net Investment = Gross Investment Value- Unearned finance Income.

Unearned Finance Income; it is difference between

1. Gross Investment in the lease; and

2. The present value of

(i) The MLP under a fiancé lease from the standpoint of the lessor; and

(ii) Any unguaranteed residual value accruing to the lessor, at the interest rate implicit in the lease.

Implicit Interest Rate; it is that discount rate which at the inception of the lease makes the aggregate present value of the following just equal to the fair value of the leased asset;-

1. MLP( from lessor’s perspective) under a finance lease to be added with;

2. Unguaranteed Residual Value accruing to the lessor.

Incremental Borrowing rate of interest; it the rate of interest that the lessee would have to pay on a similar lease. It the rate, which a lessee has to pay if it borrowed from market other than assets leased by it.

Contingent Rent; it is generally not fixed but based on a factor other than just passage of time. Such as sales, amount of uses, price indices or market rate of interest.

Non-Cancellable Lease; it is cancellable only;

1. Upon the occurrence of some remote contingency; or

2. With permission of lessor; or

3. If the lessee enters into new lease for the same asset or equivalent asset with the lessor ;or

4. Upon payment of additional lease payment by the lessee at the inception of the lease to ensure that the lease will reasonably certain

Implicit Interest Rate: discount rate that makes present value of Gross Investment just equal to fair value (arms’ length price) of leased asset.

Lease Incremental Borrowing rate of interest; Rate of interest that the lessee would have to pay on a similar lease.

Fair Value; Amount for which an asset could be exchanged or a liability settled at arms’ length.

Residual Value; Estimated Fair Value of the asset at the end of lease term. It may be

1. Guaranteed Value; which is guaranteed by the lessee or by a third party on behalf of lessee.

2. Unguaranteed Value; Residual Value (-) Guaranteed Residual Value.

Economic Life;

1. A period over which an asset is expected to be economically usable by one or more users; or

2. The number of production or similar units expected to be obtained from the asset by one or more users.

Useful Life;

1. The period over which the leased asset is expected to be used by the lessee; or

2. The number of production or similar units expected to be obtained from the use of the asset by the lessee.

ACCOUNTING TREATMENT OF FINANCE LEASE;

IN THE BOOKS OF LESSOR;

1. Recognize as receivable at an amount equal to net investment.

2. Recognize finance income in Profit &Loss Account; ensure constant periodic return on net investment outstanding.

3. Reduce lease payments from principal & unearned finance income.

4. Increase in unguaranteed residual value not recorded for, decrease revise income allocation.

5. Allocate initial direct costs against finance income over lease term or recognize immediately as an expense.

6. Record profit as per sales policy of the entity.

IN THE BOOKS OF LESSEE;

1. Recognize lease as an asset & liability at inception.

2. Record at fair value at inception of the lease not exceeding present value of MLP.

3. Apportion Lease Payment brought forward finance charges and reduction in outstanding liability during the lease period.

4. Charged depreciation on the leased asset as applicable.

ACCOUNTING TREATMENT OF OPERATING LEASE;

IN THE BOOKS OF LESSOR;

1. Do not recognize profit on sale.

2. Show asset on lease and fixed asset in accounting books.

3. Recognize Cost and depreciation as expenses in accounting books.

4. Allocate initial direct costs over lease term in proportion to the recognition of rent income or treat them as period expense.

5. Recognize leases income on a straight line basis, unless other basis justified.

IN THE BOOKS OF LESSEE;

1. Recognize lease payments as an expense on straight line basis unless other basis is justified.

DISCLOSURES OF FINANCE LEASE IN FINANCIAL STATEMENTS;

LESSOR;

1. Reconciliation of brought forward Gross Investment and Present Value of MLP receivables at the Balance Sheet date.

2. Unearned finance Income.

3. Unguaranteed Residual Value.

4. Accumulated provisions for unearned MLP receivables.

5. Contingent Rent Recognized.

6. General Description of significant leasing agreements.

7. Accounting policies for initial direct costs.

LESSEE;

1. Segregate Lease asset from owned assets.

2. Net Carrying amount at the Balance Sheet date for each class of assets.

3. Reconciliation of brought forward MLP at Balance Sheet date and present value.

4. Contingent Rent recognized.

5. Future minimum sub-lease payments to be received under non-cancellable sub-leases.

6. General Description of significant leasing agreements.

7. Depreciation according to AS 6 and Fixed assets according to AS 10.

DISCLOSURES OF OPERATING LEASE IN FINANCIAL STATEMENTS;

LESSOR;

1. For each class of assets

• Gross carrying amount
• Accumulated & Period depreciation charged
• Accumulated & Period impairment loss
• Impairment loss reversed for the period

2. Future MLP under non-cancellable lease term.

3. Contingent rent recognized.

4. General description of significant leasing agreements.

5. Accounting policies for initial direct costs.

6. Depreciation according to AS 6 and Fixed assets according to AS 10.

LESSEE:

1. Future MLP under non-cancellable lease.

2. Future minimum sub-lease payments.

3. MLP & Contingent rent recognized.

4. Sub-lease payments recognized.

5. General description of significant leasing agreements.

SALE & LEASE BACK TRANSACTION;

FINANCE LEASE; defer any excess or deficiency of sale proceeds over carrying amount and amortize it over lease term in proportion of depreciation on leased asset.

OPERATING LEASE; Let’s consider Sale Price of leased asset is A and Fair Value is B;

1. If A=B, Recognize profit or loss immediately.

2. If A>B defer excess over Fair Value and amortize it over a period for which asset is expected to be used.

3. If A<B if loss is compensated by future lease payments at below market price then defer it and amortize in proportion to lease payments over expected period of use or else recognize it immediately in the profit and loss account.