As per Accounting Standard 19 (Leases):
♣ A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.
♣ A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset.
♣ An operating lease is a lease other than a finance lease.
Classification of Lease
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.
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:
1. the lease transfers ownership of the asset to the lessee by the end of the lease term;
2. the lessee has the option to purchase the asset 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;
3. the lease term is for the major part of the economic life of the asset even if title is not transferred;
4. 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
5. the leased asset is of a specialised nature such that only the lessee can use it without major modifications being made.
Substance over legal form
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.
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.
If Asset and Liability not recognized in balance sheet?
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.
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) 6, Depreciation Accounting. 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.
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.
Income Tax Aspect
While the accounting standards addresses the companies act perspective, from the Income tax aspect, when the lessee incorporates both the asset and liability in the balance sheet and recognizes the depreciation expense in relation to the asset addition, the same is not allowed in the income tax act, due to the following reason:
1. the basic condition for claiming depreciation under income tax act is ownership and usage of asset, though the condition of usage of the asset is more or less settled issue, but the ownership of the asset under income tax act continues to be an point of debate.
2. As per the finance lease, the lessor is the owner of the asset legally and the lessee is only given a right to use the asset for a predetermined payment.
3. As per recent Supreme Court pronouncement also it is clear that only the lessor is eligible to claim depreciation on the leased asset, even though as per the companies act the asset is in the books of the lessee.
4. So as per the accounting standards, when the company discloses the lease to be an finance lease, the said depreciation as per the companies act is disallowed and no depreciation is allowed for the said asset in the income tax computation, as the asset is not legally owned by the lessee.
5. But the full finance charges paid by the lessee towards the assets will be allowed while computing the income tax
It is necessary to bear in mind this difference in the treatment of finance lease both in companies act and income tax act as it may cause hassle at the year end.
In case the asset is purchased by the lessee at the end of the lease term by making additional payment, the same shall be depreciated in the corresponding year under the income tax act as the ownership is transferred to the lessee.