1.34     Query

Accounting treatment of finance lease and

sale and lease-back transactions.

1.A large oxygen manufacturing company has incurred substantial amount towards acquisition of oxygen cylinders through lease agreements with finance companies and leasing companies. The company has arranged to acquire cylinders through finance lease, i.e., the finance company will arrange for funds for the purchase of new cylinders from the manufacturers in their own name and give them to the company in terms of lease for a specific period. The lessor company charges interest as finance charges and recovers both the cost of its investments in cylinders and interest charges in specific monthly instalments. As per the lease term, the lessor will sell the cylinders at the nominal value, say, at 1% or 2% of the cost of cylinders depending upon the agreement.

2.On the other hand, the company has also made arrangements with leasing companies for availing finance on sale and lease back arrangements. In this transaction, the cylinders will not physically move from the company. The cylinders are invoiced in favour of the leasing company at the prevailing market value for each such agreement. The profit or loss on such transaction is being immediately recognised and recorded in the books of the company. No depreciation has been provided or charged on those cylinders, since the company is not the owner. The company is repaying the finance availed in monthly instalments including the reasonable rate of interest. It is agreed that at the expiry of the lease agreement, the cylinders shall be sold to the company at the nominal value as referred above in another type of transaction.

3.In both the transactions referred above, the company is charging the entire amount as an expenditure in the profit and loss account.

4.In view of the recommendations contained in para 25 of the ‘Guidance Note on Accounting for Leases’ (Dec., 1988) issued by the Research Committee of the Institute of Chartered Accountants of India, the querist has referred the following issues for the opinion of Expert Advisory Committee:

(a)        Whether, in the facts and circumstances of the case, the company will be correct in charging only the interest element of the lease rentals to profit and loss account and the remaining portion of the lease rentals representing the principal amount be treated as “Deferred Capital Expenditure” which will be disclosed in the balance sheet. On the expiry of the lease term the same will be transferred to capital expenditure under “Cylinder Account” with a specific disclosure in the annual accounts as recommended in para 24 of the Guidance Note on Accounting for Leases.

(b)        If the said treatment is correct, whether the amount charged in profit and loss account till 31-3-1988 on unexpired lease agreements can be reversed and credited to the profit and loss account in the current financial year.

                                                                                                   Opinion                                           August 3, 1990   

“4. A lease is classified as a finance lease if it secures for the lessor the recovery of his capital outlay plus a return on the funds invested during the lease term”

The Committee is accordingly of the view that the two types of transactions referred to in the query are in the nature of finance lease.

2.The Committee notes the relevant recommendations contained in the ‘Guidance Note on Accounting for Leases’, issued by the Research Committee of the Institute of Chartered Accountants of India, which are reproduced below:

            “Finance Leases

Accounting for leases in the Books of Lessee

24.A lessee should disclose assets taken under a finance lease by way of a note to the accounts, disclosing, inter alia, the future obligation of the lessee as per the agreement.

25.Lease rentals should be accounted for on accrual basis over the lease term so as to recognise an appropriate charge in this respect in the profit and loss account, with a separate disclosure thereof. The appropriate charge should be worked out with reference to the terms of the lease agreement, type of the asset, proportion of the lease period to the life of the asset as per the technical/commercial evaluation and such other considerations. The excess of lease rentals paid over the amount accrued in respect thereof should be treated as prepaid lease rental and vice versa.”

3.The Committee is of the view that the appropriate charge to the profit and loss account, in the facts and circumstances of the query, would be:

(i) the interest element of the lease rentals paid/payable by the lessee during the relevant period, and

(ii) a periodical lease charge which is arrived at as suggested in para 4 below:

The lease rentals for the period in excess of the interest element and the periodical lease charge, should be treated as ‘prepaid lease rentals’ or vice-versa. At the end of the lease period, the balance in the ‘Prepaid Lease Rentals Account’ should be transferred to the asset account and would represent the cost of the leased asset purchased from the lessor company.

4. The periodical lease charge should be arrived at as below:

(i) the excess of the aggregate minimum lease payments payable in respect of the lease, over the total interest, should first be computed;

(ii) the amount so computed should then be allocated over the life of the asset to be determined as per the technical/commercial evaluation, the relevant applicable laws, e.g., the Companies Act, 1956, to arrive at the periodical lease charge.

5. The Committee is accordingly of the following opinion in respect of the issues raised in para 4 of the query:

(a) The company should charge not only the interest element of the lease rental charges to the profit and loss account, but also the periodic lease charge as arrived at in para 4 above. The excess of the lease rentals over the interest and the periodic lease charge should be shown under ‘Prepaid Lease Rentals Account’ (or vice-versa) and on the expiry of the lease term, the same should be transferred to ‘Cylinders Account’. The disclosure should be made as suggested in para 24 of the ‘Guidance Note on Accounting for Leases’. Such a treatment would mean a change in the accounting policy. Accordingly, the fact of the change in accounting policy together with its impact should be disclosed as recommended in para 12 of Accounting Standard (AS) 5 on ‘Prior Period and Extra Ordinary Items and Changes in Accounting Policies’, issued by the Institute of Chartered Accountants of India, which is reproduced below:

“12 Any change in an accounting policy which has a material effect should be disclosed. The impact of and the adjustments resulting from such change, if material, should be shown in the financial statements of the period in which such change is made to reflect the effect of such change. Where the effect of such change is not ascertainable, wholly or in part, the fact should be indicated. If the change is made in the accounting policies which has no material effect on the financial statements for the current period but which is reasonably expected to have a material effect in the later periods, the facts of such change should be appropriately disclosed in the period in which the change is adopted.”

(b) According to Paragraph 27 of the ‘Guidance Note on Accounting for Leases’: “This Guidance Note is recommended for application in respect of lease transactions entered into in the accounting period beginning on or after 1^st April, 1989.” However, the company can apply the treatment suggested in para (a) above to the lease transactions entered into in accounting period/s beginning before 1.4.1989. This will give rise to an adjustment in the profit and loss account of the current year which should be disclosed as per para 12 of AS 5 on ‘Prior Period and Extra Ordinary Items and Changes in Accounting Policies’, as reproduced above.

___________________________