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Query No. 9
Subject: Accounting treatment of lease deposits received for lease of land by the company engaged in development of software technology parks.
A. Facts of the Case
1. A company is a wholly owned Government of Tamil Nadu Undertaking incorporated on 21st March, 1977 under the Companies Act, 1956 and is having its registered office at Chennai. The authorised share capital of the company is Rs. 30.00 crore consisting of 3,00,000 equity shares of Rs. 1000/- each and the paid-up share capital is Rs. 25,93,05,000/-. The entire share capital has been subscribed by the Government of Tamil Nadu.
2. The company was formed with the main objective of promoting electronics industry in the State and nurture them. The business activities of the company include promotion of software technological parks in tune with the policy of the Government of Tamil Nadu to promote software industry in the State. With this aim, the company is setting up Information Technology (IT) parks at Chennai and other tier II cities as per the guidelines under the Special Economic Zones Act, 2005 (SEZ Act) read with the Special Economic Zone Rules, 2006 (SEZ Rules).
Category I
3. The querist has stated that the company has, inter alia, been leasing out land to IT companies and was collecting lease deposits upfront for the lease of land from the lessee IT companies. Initially, the lease deposit was 100% repayable when the lessee surrenders the land as per the lease agreement entered into between the company and the lessee IT companies. The lease deposits so collected in the previous years have been disclosed as ‘Land Lease Deposit’ under the head ‘Loan Funds’ which had not been objected by the Comptroller and Auditor General of India (C&AG) /Accountant General until financial year 2009-10. A sample copy of such a lease agreement has been supplied by the querist for the perusal of the Committee.
Category II
4. The querist has also stated that since 22.12.2010, the company is collecting lease deposits with the condition that 15% of the amount will be forfeited if the lessee surrenders the land within a period of 3 years and for subsequent periods, 5% of the lease deposit will be forfeited from the 4th year onwards. Only 15% of the lease deposit collected is repayable after the expiry of 17 years or subsequently. This has been stated at 3.01 (n) of the ‘Statement of Significant Accounting Policies’ in the accounts of the company for the year ending 31.03.2011 and subsequent years also. A copy of this category of agreements entered into with the lessee has also been supplied by the querist for the perusal of the Committee. Relevant extracts of C&AG’s comments on the annual accounts for 2010-11and 2011-12 have been provided by the querist as given below:
“2010-11
A. Source of Funds
Current Liabilities and Provisions – Rs. 679.60 crore
This includes a sum of Rs. 226.68 crore being the sale value of plots allotted in various SEZs. This should have been treated as income as the transfer of ownership to the lessees amounted to sale and accounted for accordingly. This has resulted in overstatement of current liabilities and provisions and understatement of income to that extent.
B. Application of Funds
Fixed Assets – Sch.1.05 – Land – Rs. 337.47 crore
The above includes a sum of Rs. 229.50 crore being the cost of 783.71 acres of land which is saleable in nature. The same should be classified as ‘stock-in-trade’ under ‘Current Assets’. Inclusion of the same under above head has resulted in overstatement of fixed assets and understatement of current assets to the extent of Rs. 229.50 crore. These comments of C&AG are based on the opinion given for query no. 22 of Volume XX of the Compendium of Opinions, issued by the Expert Advisory Committee of the Institute of Chartered Accountants of India (ICAI).
2011-12
Non-current Liabilities and Provisions - Long Term borrowings - Rs. 273.94 crore.
This includes a sum of Rs. 273.82 crore being the amount received as lease deposits which should have been accounted as income treating the long term lease as sale. Non-accounting has resulted in overstatement of liabilities and understatement of income and profit to that extent.
Non-current Assets – Fixed Assets – Tangible Assets – Land Rs. 337.47 crore
The above includes a sum of Rs. 113.24 crore being the cost of 783.69 acres of land which is saleable in nature. The same should have been classified as ‘stock-in-trade’ under ‘Current Assets’. Inclusion of the same under above head has resulted in overstatement of fixed assets and understatement of current assets to the extent of Rs. 113.24 crore.”
5. According to the querist, the above comments given by the C&AG were based on the opinion given by the Expert Advisory Committee of the ICAI in the case of a company, which was presumably based on commercial leases. The company in this case is coming under the SEZ Act and SEZ Rules, 2006 which came into force from 10th February, 2006, which provides that these lands cannot be sold. The Board of Directors of the company examined the matter in detail besides considering the professional advice from three opinions which included lawyers and chartered accountants and decided that the company may write to the Institute of Chartered Accountants of India for expert opinion in the matter.
6. The querist has also stated that as observed by C&AG, Rs. 226.68 crore represents the lease deposits received from prospective IT companies, which have taken lands in various special economic zones on lease from the company for periods ranging upto 99 years. The Government of India (GOI) granted the company, through various Gazette notifications, approval for development and operation of sector specific special economic zones for information technology enabled services at various places in Chennai, Trichy, Madurai, Coimbatore, Salem and Thirunelveli. The company as sector specific developer of SEZ leased the land to the prospective entrepreneurs for 90/99 years lease. These leases of land are governed by the SEZ Act, 2005 and SEZ Rules, 2006. Section 11(9) of the SEZ Rules prohibits sale of land by the developer in any SEZ and section 51 of the SEZ Act overrides all other Acts. As per the querist, in view of the specific provisions in the SEZ Act and SEZ Rules, the non-compliance with these provisions may lead to cancellation of the status of ‘Developer of SEZ’. Thus, as a Developer of SEZ, the company has to comply with the Acts and Rules under SEZ and hence, the lease cannot be considered as sale and the lands in question in SEZ remain with the company. Hence, it had to account the lease deposit at the beginning of the lease period under ‘Loans & Advances’ head only.
B. Query
7. In the above circumstances, the querist has sought the opinion of the Expert Advisory Committee as to whether the accounting treatment of the land lease deposits and lease hold land already given by the company in the accounts upto 2010-11/ 2011-12 is in order.
C. Points considered by the Committee
8. The Committee notes that the basic issue raised by the querist relates to accounting treatment of land lease deposits received by the company and land given on lease by the company in the two categories of lease agreements, a sample copy of each of which has been supplied by the querist for the perusal of the Committee. The Committee has, therefore, considered only this issue and has not considered any other issue that may arise from the Facts of the Case, such as, accounting for acquisition of land by the company from the Government, accounting for development expenditure incurred by the company, accounting for lease rent, service charges, annual maintenance charges and the sum received by the company in respect of development expenses, timing of recognition of lease income over the period of lease, interpretation of SEZ Act and SEZ Rules, etc. In the facts and circumstances of the company, the Committee has presumed that the company is not acting as an agent of the Government. The Committee has also presumed from the Facts of the Case that land lease deposit is payable by the lessee only in respect of lease of land and is not towards development expenditure.
9. The Committee notes the following paragraphs of the Technical Guide on Accounting for Special Economic Zones (SEZs) Development Activities, issued by the Research Committee of the ICAI in the year 2010:
“16. Although, Accounting Standard (AS) 19, Leases, excludes from its scope the leases of land, yet, for the purpose of this Technical Guide, for accounting by Developer as the lessor, the principles of AS 19 should be used even in case of accounting for leases of land. Accordingly, leases of land should be classified as operating or finance leases in the same way as leases of other assets. In determining whether land is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life and, if title is not expected to pass to the lessee by the end of the lease term, there is a strong indication that lessee does not receive substantially all of the risks and rewards incidental to ownership, in which case the lease of land will be considered as an operating lease. Accordingly, in such cases, the Developer shall present land in his balance sheet as its asset.”
“30. Where a Developer leases land on operating lease as discussed in paragraph 16, lease income should be recognised 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, in accordance with AS 19.
31. The lease deposits received before the inception of the lease (which is the earlier of the date of the lease agreement and the date of a commitment by the parties to the principal provisions of the lease) should be considered as ‘income received in advance’ to the extent the deposits are not refundable. The income from lease should be recognised in the statement of profit and loss only after the inception of the lease as discussed in the above paragraph.”
From the above, the Committee notes that the principles enunciated in AS 19 can be applied in the case of lease of land also. Further, the Committee is of the view that in the case of lease of land, considering its indefinite economic life and if title to the land is not expected to be transferred, ordinarily, lease of land would be classified as an operating lease unless there are other facts that demonstrate that lease is of the nature of ‘finance lease’, such as, at the inception of lease, the present value of various payments related to use of land during or at the beginning of the lease amounts to substantially the fair value of land, etc. In this context, the Committee notes the following provisions of AS 19:
“3.2 A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset.
3.3 An operating lease is a lease other than a finance lease.
3.4 A non-cancellable lease is a lease that is cancellable only:
(a) upon the occurrence of some remote contingency; or
(b) with the permission of the lessor; or
(c) if the lessee enters into a new lease for the same or an 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.”
“3.6 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.”
“8. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than its form. Examples of situations which would normally lead to a lease being classified as a finance lease are:
(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
(d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and
(e) the leased asset is of a specialised nature such that only the lessee can use it without major modifications being made.
9. Indicators of situations which individually or in combination could also lead to a lease being classified as a finance lease are:
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual fall to the lessee (for example in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and
(c) the lessee can continue the lease for a secondary period at a rent which is substantially lower than market rent.”
From the above, the Committee notes that whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than its form and requires exercise of judgement considering various factors peculiar to the lease agreement, as prescribed in paragraphs 8 and 9 of AS 19, such as, transfer of ownership of the asset at the end of lease term, option to purchase the asset at the end of the lease term, present value of lease payments, conditions for cancellation, etc. The Committee notes that in the extant case, SEZ Act prohibits sale of land in any SEZ and thus, the legal title of land is not expected to be transferred during or at the end of lease term. Further, the Committee notes from the lease agreement (a copy of which has been supplied by the querist for the perusal of the Committee) that in case of Category I type of leases, there is 100% refundable deposit and a nominal lease rent of Re. 1 per year over the period of lease which does not appear to be the fair value of leased asset (land). Further, the lease agreement states that in case of surrender of lease of the land by the lessee to the lessor prior to the end of the period of lease of 90 years, the refund of the land deposit shall be made by the lessor to the lessee which indicates that the lessee has the option to cancel the lease before the initial lease period. Also, the lessee cannot directly/indirectly transfer/sell/assign/sublet, etc. the leased property in any manner whatsoever and can utilise the leased property only for the purpose for which it has been granted indicating that the lessee does not have discretion on the use of the leased property. The Committee is of the view that all these factors do not indicate that the lease is of the nature of finance lease and accordingly, it should be considered as an operating lease.
10. In case of Category II type of leases, the Committee notes from the copy of the lease agreement supplied by the querist for the perusal of the Committee that there is a lock-in-period of only 3 years during which the lessee cannot exit/surrender the property and after that, the lessee shall be entitled to surrender the property and will be entitled to receive the lease deposit after deduction of minimum 15% and maximum 85% depending upon the lease term. Also, there are restrictions on the utilization of the leased property and direct/indirect transfer/sale/assignment, etc. of the lease without the prior consent of the lessor except to its wholly owned subsidiary company or the company in which the lessee holds 51% or more of the total share capital with controlling stake, which indicate that the lease is not of the nature of finance lease. However, if there are other facts which demonstrate otherwise, such as, at the inception of lease, the present value of various payments related to use of land including non-refundable lease deposit during or at the beginning of the lease amounts to substantially the fair value of land, the lease is classified as finance lease. Similarly, other terms such as, renewability clause with an option to lessee to renew the lease for a further such term on such terms and conditions as may be mutually agreed between the lessor and the lessee, etc., may indicate that the lease is a finance lease. Thus, whether the lease in this category is an operating lease or finance lease would depend upon the facts and circumstances and accordingly, the company should consider various factors, as discussed above, and decide whether to classify the lease as operating or finance lease.
11. Accordingly, the Committee is of the view that in case of Category I type of leases and in case of Category II if the lease is classified as an operating lease, the company should recognise the land in its financial statements as its own fixed asset. Further, the land lease deposits to the extent these are non-refundable should be considered as ‘income received in advance’ and the income from lease should be recognised in the statement of profit and loss only after the inception of the lease 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, in accordance with AS 19. In this regard, the Committee wishes to point out that the lease term should be determined as the initial non-cancellable period and any further period for which the lessee has the option to continue the lease and it is reasonably certain that the lessee will exercise such option at the inception of lease. In case of Category II type of leases, if the lease is classified as finance lease, the company should recognise the transaction in accordance with the requirements of AS 19. With regard to the disclosure requirements, the Committee notes that as per revised Schedule VI to the Companies Act, 1956, “a liability shall be classified as current when it satisfies any of the following criteria:
(a) it is expected to be settled in the company’s normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is due to be settled within twelve months after the reporting date; or
(d) the company does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting date. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification.
All other liabilities shall be classified as non-current.”
12. On the basis of the above, the Committee is of the view that land lease deposits to the extent expected to be recognised as income within next twelve months after the reporting period, should be classified as ‘other current liabilities’ under ‘Current Liabilities’ and remaining land lease deposits should be classified as ‘Other long term liabilities’ under ‘Non-current liabilities’ as per point (c) stated above. Further, refundable land lease deposits to the extent these are due to be settled within twelve months after the reporting date should be classified as ‘Current liabilities’ and the balance should be classified as ‘Non-current liabilities’. The Committee is also of the view that upto the year 2010-11, to the extent, the land lease deposits are refundable, these should be treated and disclosed under ‘Current Liabilities’ as per the requirements of pre-revised Schedule VI to the Companies Act, 1956.
13. The Committee also notes certain distinguishing features in the extant case which were not existing in the facts of earlier opinion of EAC issued on 8.8.2000, referred by the querist, are applicability of SEZ Act, 2005 and SEZ Rules, 2006 which prohibits sale of land in the SEZ, which was not applicable in the earlier opinion of EAC, issuance of Technical Guide by the Research Committee of the ICAI in the year 2010 etc. Similarly, other terms relating to lease premium, transferability of lease by the lessee, etc. are different from the facts of the extant case and accordingly, the earlier opinion cannot be applied in the extant case.
D. Opinion
14. On the basis of the above, the Committee is of the opinion that the land in Category I type of leases and in Category II, if lease is classified as an operating lease considering various factors as discussed in paragraph 10 above, should be treated as the fixed asset of the company in its financial statements. For Category II type of leases, which are classified as finance lease, the company should recognise the transaction in accordance with the requirements of AS 19. Where the lease is considered as operating lease, the land lease deposits to the extent these are non-refundable should be considered as ‘income received in advance’ and the income from lease should be recognised in the statement of profit and loss only after the inception of the lease 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, in accordance with AS 19, as discussed in paragraph 11 above. Further, land lease deposits to the extent expected to be recognised as income within next twelve months after the reporting period, should be classified as ‘other current liabilities’ under ‘Current Liabilities’ and remaining land lease deposits should be classified as ‘Other long term liabilities’ under ‘Non-current liabilities’. The refundable land lease deposits to the extent these are due to be settled within twelve months after the reporting date should be classified as ‘Current liabilities’ and the balance should be classified as ‘Non-current liabilities’. Upto the year 2010-11, the land lease deposits to the extent these are refundable should also be treated and disclosed under ‘Current Liabilities’, as per the requirements of pre-revised Schedule VI to the Companies Act, 1956, as discussed in paragraph 12 above.
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[1]Opinion finalised by the Committee on 1.5.2014.
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