1.28 Query
Accounting treatment for a sale and leaseback transaction.
1.A large manufacturer and marketeer of chemical fertilisers, namely, urea, dia-ammonia-phosphate and complex fertilisers, has an annual turnover around Rs. 200 crores. To ensure high plant up-time and high capacity utilisation, the company’s policy has been to incur a substantial amount on preventive maintenance. Its maintenance expenditure is of the order of Rs. 7 to Rs. 8 crores per annum. In addition, the company maintains a large inventory of spare parts in its stores which can be issued to the plant for replacing worn-out or damaged parts. The total value of such spares known as ‘Insurance Spares’ exceeds Rs. 2 crores. These spares are with the company for many years and are valued at historical cost. In case of more than one item for each category, the value is taken at average historical cost.
2.The company generally follows the mercantile system of accounting. The above ‘Insurance Spares’, when purchased by the company are taken into Stores through a GRIN and reflected in ‘Stores and Spares’ inventory under the current assets schedule of the balance sheet. When any of these spares are required in the plant the same is issued with a MRIN and the value of the spare part so issued is immediately charged off as expenditure under the heading ‘Repairs and Maintenance’.
3. In view of the high opportunity cost of the company’s funds which are currently tied up in these ‘Insurance Spares’, the company had been looking into various alternative means of financing these. One such method currently under consideration is a ‘Sale and Leaseback’ arrangement with a reputed leasing company.
4.It is proposed to sell the entire inventory of ‘Insurance Spares’ to a reputed leasing company (hereinafter referred to as the ‘Lessor’). The lessor will, in turn, leaseback spares to the company. It may be noted that in this transaction the spares will not physically move from the company’s stores. The tenure of the lease will be 10 years. The first five years of which will be designated as the primary period. During the primary period, the lessor will charge the lease rental which would essentially enable him to recover his principal and interest cost. The rentals can be either uniform for all the 5 years or structured on a declining or increasing basis. However, on all three basis, the concept of capital recovery with interest within the primary period of 5 years will hold good. During the secondary period of 5 years, the lessor will charge nominal lease rental of say Rs. 100/- per month. At the end of the 10th year the lessor will sell back to the company the above spares at a nominal price of Re. 1/-. If during the tenure of the above lease agreement, the company is in need of any of the spares covered under the said lease agreement, then the company may issue the spares to the plants by foreclosure, and the company will pay the lessor the principal amount outstanding vis-a-vis the said spare on the day of foreclosure.
5.The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:
(i) What would be the accounting treatment for the lease rental paid by the company? Would it be possible to treat the lease rental as a ‘Repairs and Maintenance’ expenditure at least to the extent of the principal component excluding finance charges? What would be the treatment for the interest element?
(ii) If answer to (i) above is in the negative, then what would be the accounting treatment if lease is foreclosed before the expiry of the lease agreement due to issue of any particular spare? Can the company show the foreclosure amount under ‘Repairs and Maintenance’?
(iii) The company intends to “sell” to the lessor the ‘Insurance Spares’ at their book value which may be less than the current market value. Would there be any objection from the Income-tax Officer stating that the sale value is undervalued? Would he assess any notional profit on this transaction? If so, is there any remedy for avoiding such a situation? It may be noted that the sale is subject to sales tax, if applicable, in the State.
(iv) Will the company be able to claim the lease rental as a deduction while filing its tax returns? Is there a possibility of the ITO disallowing the same on the ground that the spares leased have not been put to use? Incidentally, the lessor, in his books, would not be claiming depreciation on these spares.
(v) Would sales tax have to be paid on spares on which the lease agreement is foreclosed?
(vi) What disclosures in the company’s Annual Report would need to be made in respect of this transaction?
Opinion May 23, 1989
1.The Committee notes that the Research Committee of the Institute of Chartered Accountants of India has issued a Guidance Note on Accounting for Leases, which distinguishes between a ‘finance lease’ and an ‘operating lease’.
2. As per para 3 of the said Guidance Note, ‘Finance Lease’ has been defined as “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 asset.” Para 4 of the Guidance Note further states that “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.” “A lease other than a finance lease is an operating lease”.
3.The Committee is of the view that the lease of the insurance spares by the lessor is a finance lease since it secures for the lessor the recovery of his principal amount plus interest during the primary period of the lease. The lease, in respect of a spare, can be considered to be non-cancellable even though it can be terminated when the company requires the spares since as per the agreement between the lessor and the vendor lessee such a termination (foreclosure) is permissible and as per the definition of the ‘non-cancellable lease’ given in para 3 of the said Guidance Note, “a lease that is a cancellable…. with the permission of the lessor,…..” would be considered as non-cancellable lease.
4.With regard to accounting for sale and lease back transactions, the Committee notes that the aforesaid Guidance Note recommends as below:
“21. A sale and leaseback transaction involves the sale of an asset by the vendor and the leasing of the same asset back to the vendor. The rentals and the sale price are usually interdependent as they are negotiated as a package and may not represent fair values.
22. If in the case of a leaseback, the rentals and the sale price are established at fair value, there has in effect been a normal sale transaction and any profit or loss is normally recognised immediately. If the sale price is below fair value any profit or loss is recognised immediately, except that, if the loss is compensated by future rentals at below market price, it is deferred and amortized in proportion to the rental payments over the useful life of the asset. If the sale price is above fair value, the excess over fair value is deferred and amortized over the useful life of the asset.”
5.With regard to other accounting treatments and disclosures in the books of the vendor lessee, the Committee notes that aforesaid Guidance Note recommends as below:
“Accounting for Leases in the Books of a Lessee
Finance Leases
“24. A lessee should disclose assets taken under a finance lease by way of a note to the accounts, disclosing, inter alia, the future obligations of the lessee as per the agreement.
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.”
6.With regard to para 25 of the Guidance Note, reproduced above, the Committee is of the view that, under the facts and circumstances of the query, the appropriate charge to the profit and loss account would be the interest element of the rentals paid by the lessee, foreclosure amount (if any) and obsolescence of spares (if any). The remaining portion of the rentals paid, representing the principal amount, less obsolescence, if any, should be treated as prepaid rentals. At the end of the primary lease period, the balance in prepaid lease rental account would, therefore, represent the cost of non-foreclosed, non-obsolete spares, less obsolescence, if any. The balance should be retained during the secondary lease period also, subject, of course, to foreclosure adjustments. At the end of the lease term, the prepaid lease rentals account should be transferred to ‘Stores and Spares Account’ and disclosed at cost less obsolescence, if any.
7. On the basis of the above, the opinion of the Expert Advisory Committee, on the issues raised by the querist in para 5 of the query, is as below:
(i) Lease rentals should be accounted for as suggested in para 6 above. In view of this, the principal component of lease rental cannot be treated as repairs and maintenance. The interest element of lease rental should be debited to the profit and loss account as the appropriate lease charge.
(ii) If a lease is foreclosed before the expiry of the lease agreement due to issue of any particular spare, the company should first transfer the foreclosure amount, i.e., the principal amount outstanding in respect of that spare to Stores Account and on actual consumption, the same should be treated a ‘repairs and maintenance’ expense.
(iii),(iv) The Committee does not wish to reply to these questions in view of &(v) Rule 2 of the Advisory Service Rules, as they involve interpretation of law only.
(vi) The company should make disclosures in its annual accounts, as recommended in para 24 of the Guidance Note on Accounting for Leases. __________________________
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