Query No. 24 Subject: Accounting for lease rentals
in the books of lessor.1
A. Facts of the Case
1. A state financial corporation incorporated under the State Financial Corporations Act, 1951, is engaged in the business of providing finance to small and medium scale industries by way of leasing of machinery and vehicles in addition to term loans.
2. The corporation maintains its accounts on cash basis for the purpose of recognition of income. Therefore, lease rentals are accounted for on actual receipt. The lease rentals received are split into income and cost recovered. The component of cost recovered in the lease rentals (hereinafter referred to as ‘capital recovery’) is charged to profit and loss account as depreciation. As per the querist, the corporation is not required to charge any statutory depreciation under any Act.
3. The statutory auditors in their report for the financial year 1998-99 have pointed out as under:-
“Depreciation on leased assets has been charged as per capital recovery method. Lease equalisation reserve has not been credited against the difference between the annual lease charge and depreciation provided on leased assets during the year as per the recommendations of the Institute of Chartered Accountants of India on lease accounting.”
4. The querist has argued that since the depreciation charged is equal to the capital cost recovered on actual receipt of lease rentals, there is no difference between the annual charge and the depreciation, and therefore, no lease equalisation reserve is required to be created.
B. Queries
5. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) Whether it is mandatory to implement the guidelines issued by the Institute in this regard.
(b) In view of the accounting system being followed by the corporation, whether it is necessary to create an equalisation reserve as advised by the Institute of Chartered Accountants of India in the ‘Guidance Note on Accounting for Leases’.
(c) Please explain the method for creation of the equalisation reserve to be followed in view of the cash system being followed by corporation and the depreciation charged.
C. Points Considered by the Committee
6. The Committee notes that there is no statutory requirement for the corporation to follow accrual basis for the preparation and presentation of financial statements, and that the corporation follows cash basis of accounting for the purpose of recognition of income whereas accrual basis is followed for recognition of expenses since depreciation on leased assets is provided for. Thus, the corporation is neither following completely the cash basis of accounting nor the accrual basis of accounting.
7. The Committee notes that one of the fundamental accounting assumptions underlying the preparation and presentation of financial statements is accrual (Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’). Therefore, the Committee is of the view that it would be appropriate for the corporation to follow accrual basis of accounting.
8. The Committee notes that the Guidance Note on Accounting for Leases 2, issued by the Institute of Chartered Accountants of India follows the accrual basis of accounting.
9. The Committee notes that the announcement on ‘Mandatory Application of Accounting Standards in respect of certain Non-Corporate Bodies’ published in the Institute’s Journal, ‘The Chartered Accountant’, January, 1994 issue, states inter-alia that “where there is no statutory requirement for preparation and presentation of financial statements on accrual basis, and the financial statements have been prepared on a basis other than ‘accrual’ the auditor should describe in his audit report, the basis of accounting followed, without necessarily making it a subject matter of a qualification. In such a case, the auditor should also examine whether those provisions of the accounting standards which are applicable in the context of the basis of accounting followed by the enterprise have been complied with or not and consider making suitable disclosures/qualifications in his audit report accordingly”. The Committee is of the view that the same principles, as stated above would apply in the case of Guidance Notes also. Thus, the provisions of Guidance Notes, to the extent applicable in the context of the cash system being followed in respect of recognition of income, would apply in the given case.
10. The Committee notes that the 'Clarification regarding Authority Attached to Documents Issued by the Institute' published in December, 1985 issue of the Institute's Journal 'The Chartered Accountant' states with respect to Guidance Notes as below:
“5.‘Guidance Notes’ are primarily designed to provide guidance to members on matters which may arise in the course of their professional work and on which they may desire assistance in resolving issues which may pose difficulty. Guidance Notes are recommendatory in nature. A member should ordinarily follow recommendations in a guidance note relating to an auditing matter except where he is satisfied that in the circumstances of the case, it may not be necessary to do so. Similarly, while discharging his attest function, a member should examine whether the recommendations in a guidance note relating to an accounting matter have been followed or not. If the same have not been followed, the member should consider whether keeping in view the circumstances of the case, a disclosure in his report is necessary.”
11. The Committee is of the view that the same authority as stated above would apply to the Guidance Note on Accounting for Leases in respect of the corporation.
12. The Committee is of the view that in the absence of any legal requirement for provision for depreciation, the depreciation should be calculated on the basis of the useful life of the asset given on lease. According to the Guidance Note on Accounting for Leases, ‘useful life’ of an asset is ‘lease term’ in case of a finance lease (paragraph 3). Accordingly, the corporation would have to create lease equalisation charge/credit as the difference between the Annual Lease Charge and the depreciation computed on the basis of the useful life. Thus, depreciation has to be provided even in a period where rental income is not recognised.
D. Opinion
13. On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 5:
(a) The Guidance Notes are recommendatory in nature. The recommendations of the Guidance Notes are ordinarily required to be followed except where in the circumstances of the particular case it may not be necessary to do so
(b) Lease equalisation charge/credit should be created as discussed in paragraph 12 above.
(c)Please refer to paragraph 12 above.
1Opinion finalised by the Committee on 8.8.2000.
2 The Accounting Standard (AS) 19, ‘Leases’, has since been issued by the Institute of Chartered Accountants of India which is mandatory in respect of all assets leased during accounting periods commencing on or after 1.4.2001. Accordingly, the ‘Guidance Note on Accounting for Leases’ would not be applicable in respect of such assets. As per AS 19, the lessor should recognise assets given under a finance lease as a receivable at an amount equal to the net investment in the lease. The finance income should be recognised in the statement of profit and loss on a pattern reflecting a constant periodic rate of return on the net investment outstanding for the period. Thus, the lessor can not charge depreciation in respect of such assets. For details, the complete text of AS 19 may please be referred to (published in the January, 2001 issue of ‘The Chartered Accountant’.)
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