1.51 Query: Accounting treatment of lease rentals received on premature closure of primary period of lease.
1.X Limited, a finance company, entered into an agreement for lease of plant and machinery with Y Limited on the following terms:
2. X Limited has a policy of charging of depreciation during the period of lease, i.e., 8 years and accordingly the company has been charging depreciation at Rs. 12,500/- per annum on straight line basis. On completion of the second year, Y Limited wants to prematurely close the primary period by paying Rs. 87,000/-. However, the secondary period continues and the lease period will be terminated only after completion of 8 years.
3. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
a) Whether X Limited can take the amount of Rs. 87,000/- paid as lease compensation as income in the third year? Depreciation being written off at Rs. 12,500/- per annum.
b) Whether X Limited can treat Rs. 87,000/- as prepaid lease rent and account it proportionately in the third, fourth and fifth year. Depreciation being charged at Rs. 12,500/- per annum.
c) Assuming that the company has a practice of charging of lease depreciation during the primary period of lease, in that case:
i) Can the company take the lease compensation of Rs. 87,000/- as income in the third year and also account for the balance depreciation of Rs. 60,000/- in the third year?
ii) Should the lease rentals received in the third year be treated as prepaid rentals and accordingly accounted during the fourth and fifth year.
Opinion February 11, 1992
1. The Committee notes the definitions of the terms ‘Finance Lease’, ‘Lease Term’, and ‘Useful Life’ as given in paragraph 3 of the ‘Guidance Note on Accounting for Leases’, issued by the Institute of Chartered Accountants of India, which are reproduced below:
“Finance Lease: A lease under which the present value of the minimum lease payments at the inception of the lease exceeds or is equal to substantially the whole of the fair value of the leased asset.
Lease Term: The non-cancellable period for which the lessee has contracted to take on lease the asset together with any further periods for which the lessee has the option to continue the lease of the asset, with or without further payment, which option at the inception of the lease it is reasonably certain that the lessee will exercise.
Useful Life: In the case of an operating lease either (a) the period over which a fixed asset is expected to be used by the enterprise; or (b) the number of production (or similar) units expected to be obtained from the asset by the enterprise. In the case of a finance lease, the useful life of the asset is the lease term.”
2.The Committee notes from the facts of the query that in the third year, the company receives Rs. 87,000/- for premature closure of the primary period but the lease term remains to be eight years. Since the lease continues, the Committee is of the view that Rs. 87,000/- is in the nature of lease rental for the third year.
3. The Committee also notes the accounting treatment for finance leases in the books of the lessor as recommended in paragraphs 10 to 13 of the abovesaid Guidance Note 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 lease 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 Profit and Loss Account and disclosed separately as a deduction from/addition to gross value of lease rentals shown under the head “Gross Income”.
(c) Statutory depreciation should be shown separately in the profit and loss account.
(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 lease 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)”.
4. The Committee notes from the facts of the query that the company X Limited has not made a matching annual charge to the profit and loss account as recommended in paragraph 11 of the abovesaid Guidance Note. The company has only provided for depreciation and has not made provision for lease equalisation charge. The Committee is of the view that the company should have made matching annual charge to the profit and loss account and the matching annual charge would have comprised of –
(a) Minimum statutory depreciation; and
(b) Lease equalisation charge.
5. The Committee presumes that the depreciation of 12.5% on SLM basis charged by the company is in accordance with the Guidance Note on Accounting for Depreciation in Companies, issued by the Research Committee of the Institute of Chartered Accountants of India.
6.The Committee is of the view that X Limited should make a provision for lease equalisation charge in respect of the first and second year in the third year. The said provision should be shown as a prior period item and disclosed as per Accounting Standard (AS) 5 on Prior Period and Extraordinary Items and Changes in Accounting Policies.
7. The Committee is accordingly of the following opinion in respect of the issues raised in paragraph 3 of the query:
(a) The company should treat Rs. 87,000/- as lease rental in the third year and the company should provide for the lease equalisation charge as recommended in para 11 of the Guidance Note. Depreciation should be charged at 12.5% per annum on SLM basis if it is in accordance with the recommendations of the Guidance Note on Accounting for Depreciation in Companies.
(b) The accounting treatment suggested by the querist in paragraph 3(b) and 3(c) of the query is not correct. _______________________________ |