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Query No. 1
Subject:
Accounting for scheduled rent increases in case of
an operating lease.1
A. Facts of the Case
1. The querist has stated that on 1st April, 2005, a company
(hereinafter referred to as ‘the lessee’) took a premises on lease
which qualifies as an operating lease under Accounting Standard
(AS) 19, ‘Leases’, issued by the Institute of Chartered Accountants
of India. The initial term of the lease is 3 years and it is renewable
at the sole and exclusive option of the lessee for two further terms
of 3 years each. As per the lease agreement, the total lease
period cannot exceed 9 years.
2. The lessee does not have the right to terminate the lease
during the first 33 months. Thereafter, the lessee has the right to
cancel the lease after giving a written notice of 3 months to the
lessor. The lessor does not have the right to terminate the lease
throughout the 9 year period.
3. The lease payments will be escalated by 10% of the last
lease rent at the end of every block of 3 years. Based on this, the
schedule of lease rent is as follows:
Years 1-3 Rs. 5,00,000 p.m.
Years 4-6 Rs. 5,50,000 p.m.
Years 7-9 Rs. 6,05,000 p.m.
4. According to the querist, in order to account for lease rentals,
the company has to take a view whether the lease term is 3 years
or 9 years. In this regard, the querist notes that AS 19 defines
‘lease term’ as follows:
“The lease term is the non-cancellable period for which
the lessee has agreed 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.”
Thus, as per the querist, the issue is whether renewal of the lease
agreement can be regarded as reasonably certain. In this regard,
a view has been expressed that reasonable certainty of renewal
exists if the rental during the period of renewal is expected to be
considerably lower than the fair market rental at the date the
option becomes exercisable, or if the lessee has made substantial
expenditure on leasehold improvements which have useful life
much in excess of the initial lease period. As per the querist, both
these conditions are satisfied in this case.
5. The querist has further stated that in case the lease term is
taken as 9 years, the issue of dealing with scheduled rent increases
arises. In this regard, the querist has reproduced paragraphs 23,
24 and 40 of AS 19 which state the following:
“23. Lease payments under an operating lease should be
recognised as an expense in the statement of profit and
loss on a straight line basis over the lease term unless
another systematic basis is more representative of the
time pattern of the user’s benefit.
24. For operating leases, lease payments (excluding costs
for services such as insurance and maintenance) are
recognised as an expense in the statement of profit and loss
on a straight line basis unless another systematic basis is
more representative of the time pattern of the user’s benefit,
even if the payments are not on that basis.”
“40. Lease income from operating leases should be
recognised in the statement of profit and loss on a straight
line basis over the lease term, unless another systematic
basis is more representative of the time pattern in which
benefit derived from the use of the leased asset is
diminished.”
6. The querist has suggested two alternative views for the
treatment of scheduled rent increases which are as follows:
• One view is that the increases in rent may only be
considered as adjustment for inflation. Accordingly, the
monthly rental for each 3 year block of the lease period
should be with reference to the lease rent payable for
that block in terms of the lease agreement. In support of
this view, it is argued that from a substantive angle, the
scheduled rent increases are in response to expected
future increases in rentals in general. The increases
represent higher cost of operating in future and it will,
therefore, be inappropriate to allocate a part thereof to
the current period.
• The other view is that the lessee will derive the same
benefit from the leased premises over the lease term. It
is not the benefit but the contractual cost of obtaining the
benefit that will undergo a change due to scheduled rent
increases. As the user’s benefits do not change over the
lease period, AS 19 gives no option but to charge the
total rentals over the 9 year lease period on a straight
line basis.
B. Query
7. The querist has sought the opinion of the Expert Advisory
Committee on the following issues:
(i) Whether the renewal of the lease for two successive
terms of three years each can be considered as being
reasonably certain at the inception of the lease. What
are the relevant factors and supporting evidence that
should be considered in this regard for demonstrating
reasonable certainty of renewal of lease? Whether it
can be accepted that presence of substantial leasehold
improvements and importance of the lease to the
business provide evidence of reasonable certainty of
renewal. Whether it is significant that even the increased
rent during the period of renewal is expected to be fairly
lower than the fair market rental at the date the option
becomes exercisable. Whether reliance can be placed
on the management representation (being the lessee)
regarding their intention to renew the agreement.
(ii) If the renewal is considered reasonably certain and
renewal period added to the lease term, how should the
lessor and the lessee account for the lease rentals during
the lease term? More specifically,
(a) Whether the scheduled rent increases over the lease
term (9 years) should be spread over the lease
term by means of recognition of lease rentals over
the lease term on a straight line basis. In such a
case, whether the monthly rental would be taken as
average rental for total lease period (i.e., 9 years).
(b) Whether uneven lease rentals (which may be due
to inflation) are permitted on the argument that this
represents another ‘systematic basis which is more
representative of the time pattern of the user’s
benefit’. In such a case, the rent expense would be
the lease rent payable for that period in terms of
the lease agreement.
(c) How should the associated leasehold improvements
in the same premises be amortised, more
specifically, if the lease term is considered to be 3
years, whether the period of amortisation should be
limited to it or whether the period of amortisation
should be determined independent of the lease term.
C. Points considered by the Committee
8. The Committee restricts its opinion on the issue of the
accounting for scheduled rent increases in the case of an operating
lease and amortisation of leasehold improvements. The Committee
presumes that the querist has correctly concluded that the lease in
question is an operating lease and not a finance lease. The
Committee has accordingly not addressed the issue of classification
of the lease into an operating lease or a finance lease within the
meaning of AS 19.
9. The Committee notes the definition of the term ‘lease term’
(reproduced in paragraph 4 above) and the requirements prescribed
in paragraphs 23, 24 and 40 of AS 19, reproduced in paragraph 5
of the Facts of the Case.
10. The Committee is of the view that whether renewal of the
lease agreement can be regarded as reasonably certain at the
inception of lease should be determined on the basis of the facts
and circumstances of the case. The factors to be considered in
this regard would include but are not limited to those mentioned by
the querist, e.g., the expectation that the rentals during the period
of renewal are expected to be considerably lower than the fair
market value of the rentals at the date the option by the lessee
becomes exercisable, the lessee has made substantial expenditure
on leasehold improvements which have useful life much in excess
of the initial lease period and importance of the lease to the
business. The Committee is of the view that the aforesaid factors
mentioned by the querist provide a strong indication that the lease
agreement would be renewed on the expiry of the 3-year and 6-year periods. The other factors can be that the lessee has entered
into business commitments, the fulfilment of which would require
renewing the lease of the premises beyond the initial lease term,
uniqueness of purpose or location of the property, the availability
of a comparable replacement property, ability or willingness of the
lessee to bear the cost associated with relocation or replacement
of the leased property at market rental rates, any past practice in
this regard in comparable circumstances, etc. Although,
representation by the management indicating their intention to
renew the lease after the initial lease term can be a factor, the
auditor will have to consider other sufficient appropriate audit
evidence indicating the existence of the aspects related to the
factors as stated hereinbefore.
11. The Committee agrees with the second view stated by the
querist in paragraph 6 of the Facts of the Case that the lessee is
expected to derive the same benefit, in physical terms, from the
leased premises over the lease term and, accordingly, the
scheduled rent increases in the lease rental do not meet the criterion
for recognising expense/income on a basis other than straight line
basis over the lease term. In other words, the Committee agrees
that the scheduled increases in the lease rentals as envisaged in
paragraph 3 of the Facts of the Case do not indicate the time
pattern of the user’s benefit necessitating recognition of expense/
income on account of lease payments on a systematic basis being
representative of that pattern. The Committee is of the view that
the Standard does not recognise inflation as a factor representing
the time pattern of the user’s benefit. The Standard also does not
incorporate adjustments to reflect the time value of money. The
Committee is, accordingly, of the view that in case it is concluded
on the basis of the definition of ‘lease term’ that the lease term is
for 9 years, the total lease rental for the lease term should be
spread over 9 years on straight line basis, thus, necessitating
creation of a liability/receivable in the initial years when the lease
payments are lower than the expense/income in this regard from
the perspective of the lessee and the lessor, respectively.
12. With regard to amortisation of leasehold improvements over
the lease term, the Committee is of the view that in case the
leasehold improvements meet the definition of the term ‘fixed asset’
as per Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’,
issued by the Institute of Chartered Accountants of India, the same
should be depreciated over their useful life. The term ‘useful life’ is
defined in paragraph 3.3 of Accounting Standard (AS) 6,
‘Depreciation Accounting’, as below:
“3.3 Useful life is either (i) the period over which a depreciable
asset is expected to be used by the enterprise; or (ii) the
number of production or similar units expected to be obtained
from the use of the asset by the enterprise.”
From the above, the Committee is of the view that in case it is
expected that the lease term is 3 years, i.e., it is not reasonably
certain at the inception of the lease that the lessee will exercise
the option to renew the lease after 3 years, the cost of the fixed
assets so created should be depreciated over 3 years because
that is considered to be the ‘useful life’ of the asset. However, if
the lease term is considered to be 9 years on the considerations
stated in paragraph 10 above, the leasehold improvements should
be amortised over the period of 9 years or over their useful life if
less than 9 years.
D. Opinion
13. On the basis of the above, the opinion of the Committee on
the issues raised by the querist in paragraph 7 above, is as below:
(i) Whether the renewal of the lease for two successive
terms of 3 years each can be considered as reasonably
certain at the inception of the lease would have to be
considered taking into consideration the factors stated
in paragraph 10 above.
(ii) If the renewal of the lease term is considered reasonably
certain and renewal period is added to the lease term,
the lessor and the lessee should account for the lease
rental on straight line basis during the lease term. In
such a case,
(a) the total lease rental over the 9 years period should
be spread over the lease term by means of
recognition of lease rentals over the lease term on
a straight line basis. Accordingly, the monthly rental
would be taken as average rental for total lease
period, i.e., 9 years.
(b) the uneven lease rentals are not permitted to be
recognised as income/expense on the basis of the
argument that the scheduled increases in the rentals
represent another ‘systematic basis’ which is more
representative of the time pattern of the user’s
benefit.
(c) the associated leasehold improvements in the same
premises, if recognised as a fixed asset within the
meaning of AS 10, should be depreciated over their
‘useful life’, as defined under AS 6 (reproduced in
paragraph 12 above). Thus, in case the lease term
is considered to be 3 years, the period of
depreciation is not independent of the lease term
as the useful life has to be considered in the context
of the lease term as discussed in paragraph 12
above.
1 Opinion finalised by the Committee on 23.3.2007
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