Expert Advisory Committee

1.34 Query:

Special depreciation on assets leased out.

1. A company, which is a Government of India Undertaking, carries on, inter alia, the business of leasing out the EPABX systems. This business was taken up by the company from 1987 onward. In 1987, the Institute had issued an exposure draft (Proposed Guidance Note on Accounting for Leases) and the company adopted these guidelines in toto.

2. Accordingly, out of the rental received, finance income was being taken at the pre-determined rate (say 14%) on net investment outstanding during the period and the balance annual capital recovery charge was spilt in two parts, i.e., normal depreciation and special lease depreciation. For instance, in 1986-87, the net investment in lease was Rs. 18,500/- and the rental received was Rs. 10,000/-. The net investment during the period as such works out to Rs. 8,500/- (Rs. 18,500 - Rs.10,000 = Rs. 8,500). The finance income works out to Rs. 1,190/-. The annual capital recovery charge (Rs. 10,000 – Rs. 1,190 = Rs. 8,810) is being spilt in two parts, normal depreciation on the asset, (say 25%) Rs. 4,625/- and the balance amount Rs. 4,185/- is being treated as the special lease depreciation. The auditors have expressed their reservations on the special lease depreciation. They have stated that due to charging of special leased depreciation, profits of the company are being understated. According to them, only the normal depreciation as per the accounting policy of the company should be charged.

3. In the accounting policy of the company, the above treatment has been fully disclosed in the accounts as under:

“LEASE ACCOUNTING

Income is recognised as a constant periodic rate of return on the Company’s net investment outstanding in the lease.

Normal depreciation is charged in the accounts on the straight line method. In case, the rental income is in excess of finance income, special lease depreciation is charged.”

4. As the above lease accounting was being followed consistently by the company, the auditors did not give any comment on the above in the accounting year 1989-90 but advised that the company should seek expert opinion on the matter. The querist has sought the opinion of the Expert Advisory Committee as to whether in view of the above policy, the special lease depreciation, if the rental income is in excess of finance income, should be charged or not.

Opinion October 28, 1991

1.The Committee notes that, as per the querist, the accounting treatment explained in para 2 of the query is in accordance with the Exposure Draft on the proposed Guidance Note on Accounting for Leases, issued by the Research Committee of the Institute of Chartered Accountants of India. The Committee, however, notes that the Exposure Draft was subsequently revised in the light of the comments received from the public and issued finally as the Guidance Note on Accounting for Leases, in December, 1988. Thus, a company which has started following the recommendations contained in the exposure draft is expected to change its treatment for accounting for leases in accordance with the recommendations contained in the Guidance Note.

2.The Committee presumes that the company is leasing out the assets under finance lease.

3.The Committee notes paragraphs 11 and 12 of the Guidance Note on Accounting for Leases, issued by the Research Committee of the Institute of Chartered Accountants of India, which are reproduced below:

“11. It is appropriate that against the lease rental, a matching annual charge is made to the profit and loss account. This annual lease charge should represent recovery of the net investment/ fair value of the leased asset over the lease term. The said charge should be calculated by deducting the finance income for the period (as per para 12 below) from the lease rental for that period. This annual lease charge would comprise (i) minimum statutory depreciation (e.g., as per the Companies Act, 1956) and (ii) lease equalisation charge, where the annual lease charge is more than the minimum statutory depreciation. However, where annual lease charge is less than minimum statutory depreciation, a lease equalisation credit would arise. In this regard, the following accounting entries/disclosures should be made:

(a) A separate Lease Equalisation Account should be opened with a corresponding debit or credit to Lease Terminal Adjustment Account, as the case may be.

(b) Lease Equalisation Account should be transferred every year to the Profit and Loss Account and disclosed separately as a deduction from/addition to gross value of lease rentals shown under the head “Gross Income”.

(d) Credit balance standing in Lease Terminal Adjustment Account at the end of the year should be shown under the head ‘Current Liabilities’. Similarly, debit balance standing in Lease Terminal Adjustment Account at the end of the year, should be shown under the head ‘Current Assets’, since it is of the nature of an expenditure the value of which is to be received in future. At the end of the lease term, the balance standing in Lease Terminal Adjustment Account should be transferred to leased asset account, and should be disclosed as recommended in (e) below.

(e) Accumulated statutory depreciation should be deducted from the original cost of the leased asset in the balance sheet of the lessor. However, in the last year of the lease term, the balance in the lease Terminal Adjustment Account should be shown as a deduction from the book value of the asset arrived at as stated earlier.

The method of income measurement suggested in this paragraph, is in consonance with the inherent nature of a finance lease.

The above method is illustrated in the Appendix to this Guidance Note.

12. The finance income for the period should be calculated by applying the interest rate implicit in the lease to the net investment in the lease during the relevant period. This method would ensure recognition of net income in respect of a finance lease at a constant periodic rate of return on the lessor’s net investment outstanding in the lease. However, some lessors use a simpler method for calculating the finance income for each of the periods comprising the lease term by apportioning the total finance income from the lease in the ratio of minimum lease payments outstanding during each of the respective periods comprising the lease term. (The total finance income from the lease is the difference between the aggregate minimum lease payments receivable over the lease term and the fair value of the leased asset at the inception of the lease.) This method may be used where the finance income in respect of all individual periods as per this method approximates the finance income for the corresponding periods determined according to the former method. It is however clarified that where this method is used, overdue lease rentals, i.e., lease rentals fallen due but not collected should not be taken into account for determining the amount of minimum lease payments outstanding during each of the respective periods comprising the lease term.”

4. The Committee, therefore, advises the company to adopt the accounting treatment as suggested in the Guidance Note on Accounting for Leases.

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