Query No. 4

Subject:     

Accounting for fixed assets acquired on lease rental basis.^[1]

A. Facts of the Case

1. A company has entered into a lease agreement with an urban development authority for a period of 99 years for the office space occupied by one of the company’s branches.  The space has been given on a lease rental of Rs. 62,400/- per annum.  The lease rental is to be enhanced by 25% every fifth year.  The company has deposited a sum of Rs. 12,48,000/- as security deposit with the authority.  As per the lease deed, this security deposit is for the due payment of rent and the authority is required to repay the said amount to the company or the nominated heir/heirs of the company or the transferee with the consent of the authority without interest on the termination of lease and after payment of all the amounts due to the authority.

2. The company has capitalised a sum of Rs. 76,38,800/-, representing the lease rentals of 99 years, under the head ‘Leasehold Building’ by creating a corresponding liability for the same amount.  The amount of lease rental pertaining to a particular year is being written off as depreciation for the year on the aforesaid ‘Leasehold Building’ and an equal amount is debited to the related liability account representing payment of lease rental for the year.

3. The querist has mentioned that during the audit for the year 1997-98, government auditors disagreed with the above mentioned accounting treatment and commented as follows:

“Building of Rs. 581.63 lakhs under schedule of Fixed Assets, includes Rs. 76.39 lakhs, being the value of the total lease rental payable in 99 years in respect of a building, for which agreement with the lessor is in the nature of taking a building on rent.  Thus, the inclusion of the above building as the Company’s asset is not justified.  This has resulted in overstatement of Fixed Assets (Gross Block) by Rs. 76.39 lakhs and accumulated depreciation by Rs. 5.54 lakhs with corresponding overstatement of Current Liabilities by Rs. 70.85 lakhs.”

4.  According to the querist, the management has contended that Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, requires that fixed assets acquired on hire-purchase basis should be shown in the balance sheet with an appropriate narration to indicate that the enterprise does not have full ownership thereof.  The company is of the view that the accounting treatment followed by it is in accordance with AS 10.

B. Query

5. The querist has sought the opinion of the Expert Advisory Committee on accounting treatment of the aforesaid leasehold building.

C. Points Considered by the Committee

6. The Committee notes that the accounting treatment followed by the company is based on the premise that the transaction of obtaining the office space on lease is in the nature of acquiring a fixed asset on hire-purchase terms.  In this context, the following definition of the term ‘hire-purchase’ as contained in the Hire-Purchase Act, 1972, assumes significance.

“ ‘Hire-purchase agreement’ means an agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement and includes an agreement under which -

(i)  possession of goods is delivered by the owner thereof to a person on condition that such person pays the agreed amount in periodical instalments, and

      (ii) the property in the goods is to pass to such person on the payment of the last of such instalments, and

      (iii)  such person has a right to terminate the agreement at any time before the property so passes”.

7. The Hire-Purchase Act, 1972, does not define the term ‘goods’ used in the above definition.  However, it provides that the words and expressions not defined therein have the same meaning as in the Indian Contract Act, 1872/Sale of Goods Act, 1930.  Section 2(7) of the Sale of Goods Act, 1930 defines the term ‘goods’ as below:

“ ‘Goods’ means every kind of movable property other than actionable claims and money; and includes stock and shares, growing crops, grass, and things attached to or forming part of the land which are agreed to be severed before sale or under the contract of sale”.

8. The Committee observes from paragraphs 6 and 7 above that the subject matter of a hire-purchase agreement must necessarily be a movable property.  As such, office space (which is an immovable property) cannot be the subject matter of a hire-purchase agreement.

9. The Committee notes that as per the requirements of the lease deed, the company has deposited a sum of Rs. 12,48,000/- as security deposit.  The amount deposited by the lessee with the lessor as security deposit is in the nature of loan recoverable in cash at the time of termination of the lease.  Accordingly, the Committee is of the view that the said amount should be disclosed under the head ‘Loans and Advances’ in the balance sheet, with proper disclosure of the nature thereof.

10. The Committee notes the following definitions of the terms ‘lease’, ‘finance lease’ and ‘operating lease’ given in the Guidance Note on ‘Accounting for Leases’ issued by the Institute of Chartered Accountants of India.

“Lease : An agreement whereby the lessor conveys to the lessee, in return for rent, the right to use an asset for an agreed period of time.”

“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.”

11. The Committee notes that paragraphs 25 and 26 of the Guidance Note recommend the following accounting treatment of leases in the books of the lessee:

“Finance Leases

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.”

“Operating Leases

26. 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.  In other words, aggregate of the lease rentals payable over the lease term should, unless another systematic basis is more representative of the time pattern, be spread over the term on straight-line basis, irrespective of the payment schedule as per the terms and conditions of the lease.  The excess of lease rentals paid over the amount accrued in respect thereof should be treated as prepaid lease rental and vice versa.”

12. The Committee observes that the Guidance Note recommends that irrespective of whether a lease is a finance lease or an operating lease, in the books of the lessee, 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 Committee further observes that from the information provided by the querist, it is not possible to determine whether from the viewpoint of the lessee, the lease is a finance lease or an operating lease.  The Committee, however, believes that considering the structure of lease rentals over the lease term, it seems proper to consider the lease rentals payable for a year as the appropriate charge for that year.  Accordingly, the Committee is of the view that the actual lease rental payable for a year should be charged to the profit and loss account of that year.

D.  Opinion

13. On the basis of the above, the Expert Advisory Committee is of the opinion that office space given by the urban development authority to the company is not in the nature of a fixed asset acquired on hire-purchase basis.  The Committee is further of the opinion that the accounting treatment followed by the company in this regard is not correct.  The correct treatment would be to charge the lease rental payable for a year to the profit and loss account of that year.

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^[1] Opinion finalised by the Committee on 4.3.1999.