Background and international accounting changes on lease accounting
The Institute of Chartered Accountants of India (ICAI) recently issued a new accounting standard no AS 19 on leases, replacing the existing Guidance Note on lease accounting. The new standard is applicable for all leases entered on or after 1st April 2001: from this, it is understood that the statement will not affect past leases. However, for practical considerations, it will be advisable for companies to switch over to the new method in respect of all lease transactions, including those which are running.
It has been made out that the new accounting standard is drawn in accordance with international accounting standard no. 17. However, this is not true as the IAS 17 itself underwent revision in 1997. ICAI’s AS 19 is based on the pre-1997 version of IAS 17.
Internationally, lease accounting continues to be in a state of flux ever since McGregor published a new approach to lease accounting under which the traditional distinction between financial and operating leases is to become irrelevant and companies are required to record as asset or liability the fair value of benefits to be derived from a leased asset and the fair value of payments to be made under the lease agreement. In other words, if during the lease period, the benefits arising from an asset exceed the lease payments, the lease is an asset even if it is an operating lease. This would, inevitably, be true in case of a financial lease anyway.
To partly implement the McGregor approach, lease accounting standards in most countries, including IAS 17, have already been revised which now requires disclosure operating leases on the balance sheet of the lessee. Further changes may be on the way, as IASB as well as the UK’s Accounting Standards Board have issued approach papers to implement the McGregor approach in full.
History of disputes
Accounting for leases in has been mired in disputes from the day go. As a matter of fact, the ICAI never strongly pursued lease accounting standards (which may also be true for other accounting standards). The first draft of accounting standard on leases was issued way back around 1983, when there was hardly any leasing in the country. This was an ad verbatim reproduction of IAS 17 (which is almost what it is now -so what the ICAI has now adopted is what it proposed almost 2 decades ago). Thereafter, around 1985, a new exposure draft was prepared by the Research Committee with contributions from Anil Khanna, R Seshasayee and Vinod Kothari, all chartered accountants. This was strongly objected to by the industry, and Association of Leasing and Hire purchase Companies filed a suit in Madras High Court and got a stay, which continued for quite some time. Around 1995, the RBI under its new powers to regulate financial companies forced the leasing companies to accept the Institute’s guidelines, which led to a new look Guidance Note on Lease Accounting getting implemented.
The new accounting standard replacing the Guidance Note has come at a time when there is hardly any leasing activity in the country. This may be the reason why the change over was so smooth, as apparently, no one was concerned!
The new statement applies to all lease contracts – financial or operating. As an important point, the statement also applies to all hire purchase contracts, which are essentially financial leases.
The standard is applicable to all lease contracts, even if such lease involves substantial services by the lessor. On the other hand, the standard does not apply to service contracts, even if the same involve provision of right to use. The distinction between a transfer of right to use, and a service contract, is relevant for several purposes and there are some very nice interpretations of this difference. There is a lease, if I transfer the right to my asset to you. There is a service, if I use my asset for your benefit. In other words, the distinction between lease and service is based on whether the use of the asset is made by the lessee, or for the lessee’s benefit by the lessor.
What are the main ingredients
The main ingredients of the accounting standard are:
As for lease transactions which are currently capitalised on the books of the lessor, the accounting will be based on financial/ operating leases.
For a financial lease, the lessor will not capitalise or depreciate the asset on his books: the lessor will merely record a receivable, at the outstanding principal value. The lessee will record the asset, as his fixed asset, and depreciate the same as per usual depreciation policies of the lessee. The lessee will record, as a liability, the present value of lease rentals payable, in other words, the principal inherent in future lease rentals.
The lessor will take to revenue only the interest or finance charges inherent in lease rentals, which will also be debited as expense by the lessee.
In case of operating leases, the lessor will account for the asset as his own asset, and depreciate the same as per regular depreciation policy of the lessor. The rentals will be recognised as income by the lessor and expense by the lessee, subject to evening out in case of structured rentals. The asset/liability will be off-the-books of the lessee.
If a sale and leaseback transactions results into a financial lease, no profit on sale will be booked by the seller-lessee who will treat the sale proceeds as a liability.
If a sale and leaseback transaction results into an operating lease, a lessee will book profit/loss on sale irrespective of the sale price of the asset, depending on the fair value of the asset.
Will it have tax implications
The fears expressed before that the new method of accounting will result into loss of tax benefits by the lessor have now been allayed. In Feb., 2001, the CBDT issued a circular clarifying that the change of accounting rules will have no bearing on the tax treatment.
That is to say, subject to other conditions for depreciation allowance, a lessor in a lease will claim tax benefits, even though he will not be reflecting the asset as his fixed asset on balance sheet. This also means that the lessor will be subjecting his gross rentals as income, even though he takes to profit and loss a/c only the finance charges inherent in rentals.
In other words, to the profit as reported in profit and loss account, the principal portion of lease rentals not recognised as income will be added for tax purposes and depreciation will be allowed.
As for the lessee, though he capitalises the asset on his financial statements, he will not be able to depreciate the asset for tax purposes. Though he takes to earnings statement only the finance charges inherent in lease rentals, he will claim the whole of the rentals as expense.
Thus, the new accounting standard leads to a new era of dichotomy between tax and accounting principles, and it will be quite a tough time for the tax officers to negotiate through this dichotomous rule. In essence, when things are tough for the tax officers, they are tougher for the tax payers!
What is a financial lease
As stated before, the new McGregor approach is that the accounting for leases is unaffected by the classification of the lease into financial or operating. What triggered the new approach is a growing realisation that smart accountants world-over have been busy creating lease structures which, though in essence, are financial leases, yet they are classified as operating leases. The other common device used by accountants to offer an off-balance sheet solution to their clients is a synthetic lease where the lessor does a financial lease to an SPV, which in turn does an operating lease to the lessee.
ICAI’s AS 19 continues with the old distinction between financial and operating leases. The crux of the accounting distinction is based on the financial lease definition.
There are 2 sets of tests to distinguish between financial and operating leases.
The first set : substance test:
The first is the catch-all “substance test”. According to this test, if substantively all the risks and rewards incident to ownership are transferred to a lessee, the lease is a financial lease. On the other hand, if substantial risks and rewards, or risk, or rewards of ownership are retained by the lessor, the lease ought to be an operating lease. It is notable that the reference here is to the risks and rewards relating to the asset, and not the credit risks or rewards.
In order for a lease to be an operating lease, it is not necessary for a lessor to retain both risks and rewards relating to the asset. If he retains asset-based risks, while transferring all the rewards (an economically unconceivable situation), the lease is an operating lease. If he retains asset-based rewards while transferring all the risks, the lease is still a financial lease as the retention of reward inherits the retention of risk: the risk of not getting the reward.
For example, if a lessor transfers all the asset-based risks, as is usually done by making the lease non-cancellable, full payout and net of all expenses, and yet the lessor retains a residual ownership which may confer to him a substantial benefit, the lease is an operating lease as the lessor has retained an asset-based benefit, and thereby also retained the risk of not getting such benefit.
As most leases, except for straight-forward hire purchase contracts or contracts bordering on hire purchase definition, retain a residual ownership of the lessor, which may arguably be a substantial benefit, it has never been easy to apply the substance test to identify financial leases. The substance test is involved and subjective, as no lease ever says in so many words what its substance is.
The second set: illustrative situations:
The accounting standard gives 5 examples of situations where a lease will be classified as a financial lease. In practice, the examples make for the rule : therefore, in practice, it is these examples which have mostly been taken as the sole guide to character-determination of leases.
The 5 examples are:
Transfer of title test – that is, the lease resulting into a transfer of title to the lessee, a characteristic of a conditional sale, and mostly not found in lease agreements, as such leases are not accepted as true leases for tax purposes.
Option to buy at bargain price such as found in case of hire purchase contracts. This option also, in countries which for tax purposes make a distinction between financial and operating leases, is normally not seen in lease contracts.
The lease term test: the lease period along with the lessee’s right of renewal covers a substantial part of the economic life of the asset. This test is also maneuverable as the economic life of an asset is indeterminate.
Full payout test: that is, if the present value of minimum lease payments accounts for substantially the whole (under IAS, 90%), of the fair value of the asset. This test is purely mathematical, and hence, objective. The discounting rate at which present value is to be computed is properly defined and hence, in practice, this test is the most important determinant of the character of a lease.
Specialised use test If the equipment is such that it can be used only by the lessee, except with major modifications. This test, as understandable, applies only to a very few leases.
So, for reasons already discussed, unless the lease is a plain hire purchase or conditional sale contract, the accounting classification has been based on the full payout test.
The full payout test
The full payout test treats a lease as a financial lease is at the inception of the lease, the present value of minimum lease payments covers substantially all the fair value of the leased asset. The practical and almost universally agreed interpretation of “substantially all the fair value” is 90%. In other words, if the lessor has a stake of more than 10 % in the residual value of the asset, he takes a significant risk and reward in the asset, and therefore, the lease ought to be classed as an operating lease.
Certain important terms need to be understood to apply the full payout test:
- Minimum lease payments refer to unconditional lease rentals which are not contingent. Minimum lease payments also include residual value guaranteed by or on behalf of the lessee. In case of the lessor, the minimum lease payments also include a residual value guaranteed by a third party.
- Minimum lease payments are to be reckoned over the lease term, that is, the non-cancellable lease period, including the period for which the lessee has a right to renew.
- Present value of minimum lease payments in case of the lessor is to be calculated at the interest rate implicit in the lease.
- The interest rate implicit in the lease, known as the IRR, is based on the minimum lease payments as well as the unguaranteed residual value.
- In case of the lessee, the interest rate implicit in the lease may not be either disclosed, or may be otherwise difficult to compute for reasons discussed later. Hence, the lessee generally uses his incremental borrowing rate for present value computation.