Expert Advisory Committee

1.36 Query:

Accounting for leased assets.

1. A corporation has been supplying plant and equipment under its leasing scheme to SSI units since 1987-88. For accounting of lease transactions, it followed the guidelines as proposed by the Institute through its journal, ‘The Chartered Accountant’ in February, 1987. Subsequently it switched over to the new guidelines as proposed by the Institute in December, 1988, with retrospective effect.

2. The accounting policy followed by the corporation is reproduced below:

“(a) Collection charges, service charges and insurance charges (management fee) have been taken as income in the year in which machine is delivered.

(b) ‘Cost of capital’ relating to outstanding net investment in leased assets have been deducted from lease rentals to arrive at ‘Recovery of capital’.

(c) The difference of ‘Recovery of capital’ and statutory depreciation is depicted through ‘Lease equalisation charges account’ as per the guidelines issued by the Institute of Chartered Accountants of India. The contra effect of ‘Lease equalisation account’ is reflected by operating ‘Lease terminal adjustment account’ in the balance sheet.”

3. During the course of audit for 1989-90, the Government auditors have expressed their reservation about the appropriateness of the accounting policy followed by the corporation in respect of lease accounting which in their opinion is not conservative. The above policy, in the opinion of the Government auditors does not appear to be a prudent policy in accordance with AS-1, insofar as it results in recognition of income which has not been realised/accrued to the company. The observations of the auditors are reproduced below:

“The above amount represents the difference of ‘Recovery of capital’ and ‘Statutory depreciation’ in respect of leased assets. The corresponding debit is reflected by operating ‘Lease Terminal Adjustment A/c.’ The Lease Terminal Adjustment A/c. is reflected under ‘current assets, loans & advances’ in the Balance Sheet. This treatment has been given by the company in accordance with their accounting policy No. 4.3 framed on the basis of a guidance note issued by the Institute of Chartered Accountants of India. The above policy of the company does not appear to be a prudent policy in accordance with the AS-1 insofar as it results in recognition of income which has not been realised by the company or accrued to the company. The profits and assets of the company have been over-stated by Rs. 26.46 lakhs due to adoption of policy which is not a prudent one as per Accounting Standard.”

4. The querist has submitted a detailed illustration explaining the accounting treatment followed by the corporation, for the perusal of the Committee. The querist has also submitted a copy of annual accounts of the corporation for the perusal of the Committee.

5. The querist has sought the opinion of the Expert Advisory Committee as to whether the accounting policy followed by the corporation is proper or not.

Opinion October 28, 1991

1. The Committee notes the accounting treatment for finance lease in the books of the lessor as recommended in paragraphs 10 to 14 of the ‘Guidance Note on Accounting for Leases’, issued by the Institute of Chartered Accountants of India, which are reproduced below:

“10. Lease rentals (those received and those due but not received) under a finance lease should be shown separately under ‘Gross Income’ in the profit and loss account of the relevant period.

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.

13. Net investment in the lease may often be equal to the capital cost/fair value of the asset at the inception of the lease. However, as per the definition, net investment is the difference between the gross investment in the lease (i.e., the aggregate of the minimum lease payments from the standpoint of the lessor and any residual value accruing to the lessor) and the unearned finance income (i.e., the difference between the lessor’s gross investment in the lease and its present value).

14. Initial direct costs, such as commissions and legal fees, often incurred by lessors in negotiating and arranging the lease should normally be expensed in the year in which they are incurred. Similarly, income on account of lease, e.g., management fees, should be recognised in the year in which they accrue.”

2. The Committee notes from the facts of the query, the illustration and the annual accounts submitted by the querist, that the corporation is following the undernoted accounting treatment:

(a) Finance income is calculated as the cost of the capital relating to outstanding net investment in leased assets.

(b) Annual lease charge is arrived at by deducting the finance income from lease rentals.

(c) Where the annual lease charge is less than the minimum statutory depreciation, the lease equalization account is credited with the difference between the minimum statutory depreciation and the annual lease charge with a corresponding debit to lease terminal adjustment account. Where the annual lease charge is more than the minimum statutory depreciation, the lease equalization account is debited with the difference between the annual lease charge and minimum statutory depreciation with a corresponding credit to lease terminal adjustment account.

(d) The lease equalisation account is transferred every year to the profit and loss account and disclosed separately as a deduction from/addition to gross value of lease rentals.

(e) Credit balance in the lease terminal adjustment account is shown under current liabilities in the balance sheet and the debit balance is shown under the head current assets.

3. The Committee notes that the corporation calculates the finance income on the basis of cost of capital relating to outstanding net investment in the leased assets. The Committee is of the opinion that the corporation should have calculated the finance income by applying the interest rate implicit in the lease to the net investment in the lease during the relevant period as recommended in para 12 of the Guidance Note reproduced above.

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