1.31  Query:    

Classification of a lease.

1.  A non-banking financial company is engaged, inter alia, in the business of consumer and commercial vehicle financing through leasing. It has taken and intends to take on lease from unrelated other companies engaged in the business of leasing assets manufactured by unrelated third parties with the right to sublease them to actual users, on the following terms:

Assets Value                                                                Rs.1,000

Security Deposit Paid                                                   Rs.300         [Interest-free]

Primary Lease Period                                                   36 months

Secondary Lease Period                                               24 months   [At Lessee’s Option]

Lease Rental During Primary Period                              Rs.24.27 per thousand per month

Lease Rental During Secondary Period             Rs.13.86 per thousand per month

The security deposit will be repaid by the lessor partly at Rs.5 per month in the last 10 months of the primary lease period by adjustment of the lease rental payments. If the lessee does not opt for the secondary lease, the security deposit remaining outstanding at the end of the primary lease period will be returned.

It is assumed that the life of the asset is equal to or more than the total lease period. If, in any case, the asset is damaged/destroyed/extinguished, the lease in respect of that asset will come to an end.

The unguaranteed residual value at the end of the primary lease period has been taken to be equal to 25% of the original asset value. The pricing of the lease has implicitly taken into account this minimum economic viability and practicable value of the asset (as can be foreseen) at the end of the primary lease period as the unguaranteed residual value of the asset.

The assets leased by the company will be sub-leased under independent agreements to sub-lessees who will be located by the company.

2.  The querist is of the view that the transaction should be accounted for as an operating lease as is commonly understood in lease accounting parlance and not as a finance lease because:

(i)         The NPV of the cash flows at the conservative prime lending rate of banks in the primary lease period is less than 90% of the Fair Market Value of the asset at the inception of the primary lease;

(ii)        The residual asset risk is borne entirely by the lessor and not by the primary or secondary lessee; and

(iii)       The lease rental for the secondary period is very high compared to the nominal rate which is the rule in any finance lease.

3.  The querist is of the view that other than general and particular principles laid out in various accounting pronouncements the world over, in India, there is no law or mandatory standard or guideline in India on accounting for operating leases.

4. The querist has sought the opinion of the Expert Advisory Committee as to what would be the proper and conservative accounting treatment of the capital and revenue flows and tax liabilities in the books of the lessor, primary lessee and secondary lessee:

           (a)        for the primary period of the lease

                        (i)         if the lessee (the company) opts for the secondary lease; and

                        (ii)        if it does not opt for the secondary lease period –

(a)     -     and the lessor sells the asset; or

(b)  -     and the lessor enters into a new lease in respect of the   same asset.

(b)        for the secondary period of the lease?

More particularly, will the nature of the transaction, viz., lease, change for tax/accounting purposes depending on whether or not the secondary lease period is taken up?

                                                                          Opinion                                 February 8, 1995

1.The Committee notes that the Institute of Chartered Accountants of India has issued Guidance Note on Accounting for Leases which deals with both the finance leases and operating leases. The Committee notes the following definitions from para 3 of the Guidance Note:

“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.

Operating Lease:         A lease other than a finance lease.

Non-Cancellable Lease:          A lease that is cancellable only:

(a)        upon the occurrence of some remote contingency,

(b)        with the permission of the lessor,

(c)        if the lessee enters into a new lease for the same or any equivalent asset with the same lessor, or

(d)        upon payment by the lessee of an additional amount such that, at inception, continuation of the lease is reasonably certain.

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.

Minimum Lease Payments:     The payments over the lease term that the lessee is or can be required to make (excluding costs for services and taxes to be paid by and be reimbursable to the lessor) together with the residual value.

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.

Residual Value:            Value estimated at the inception of lease, of the leased asset, at the expiry of the lease term.

Interest Rate Implicit in the Lease:     The discount rate that, at the inception of the lease, causes the aggregate present value of the minimum lease payments, from the standpoint of the lessor, to be equal to the fair value of the leased asset, net of any grants and tax credits receivable by the lessor.”

2. The Committee further notes that the salient features of a finance lease, and an operating lease, are given in paras 4 and 5 of the above mentioned Guidance Note which are reproduced below:

“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. Such a lease is normally non-cancellable and 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.

5.         A lease is classified as an operating lease if it does not secure for the lessor the recovery of his capital outlay plus a return on the funds invested during the lease term.” 

3. Based on the above, the Committee is of the following views regarding the arguments advanced by the querist, in favour of the lease not being a finance lease, as given in para 2 of the query:

(i)         Rate of discount implicit in the finance lease should be taken for the purpose of calculation of NPV of cash flows. Thus, the conservative prime lending rate of banks should not be considered for the said purpose.

(ii)        The Guidance Note does not lay down any specific limit of 90% for the recovery of fair value of the asset during the lease period. The Guidance Note states ‘substantial recovery’ in this regard which depends upon the facts and circumstances of the case and the normal business practice in this regard.

(iii)       The Guidance Note recommends that in case there is a recovery of capital and a return on the fair value of asset during the lease term, the lease should be classified as a finance lease. In the given case, as per the facts and figures given in para 1 of the query, during the primary lease period, the lessor gets some return by way of lease payments, including the unguaranteed residual value, since according to the Guidance Note, the residual value, whether guaranteed or not, is included in the minimum lease payments.

(iv)       Higher lease rental than that normally seen in the secondary period is not a relevant factor.

4. Based on the above, and according to the facts made available by the querist, the Committee is of the view that at the inception of the primary lease period, the querist should ascertain whether the lease is a finance lease or an operating lease for that period. Keeping in view the above parameters, the Committee feels that the lease in question for the primary period is a finance lease for the primary period. The Committee is further of the view that since the lessee has the option of opting for the secondary lease, it amounts to a renewal of the lease. Accordingly, the Committee is of the view that the company should again, at the inception of the secondary lease, consider the parameters as given in para 3 above, and decide the nature of the lease. The accounting treatments for lessor, lessee and sub-lessee should be made as per the recommendations of the Guidance Note on Accounting for Leases. The Committee refrains from giving opinion on the tax aspects of the lease transaction, in view of Rule 2 of Advisory Service Rules, which prohibits the Committee to do so.

5.  Based on the above, the following is the opinion of the Expert Advisory Committee on the issues raised by the querist at para 4 of the query:

            (a)        See para 4 above.

(b)        See para 4 above.

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