ACCOUNTING STANDARD 19: LEASES SCOPE: It shall be applicable in accounting for all leases except: (a) Lease agreements

to explore for or use natural resources, and other mineral rights; (b) Lease agreements to use lands; and (c) Licensing agreements IMPORTANT DEFINITIONS: LEASE: It is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. Lease includes hire purchase agreements also. FINANCE LEASE: It is a lease that transfers substantially all the risk and rewards incident to ownership of an asset. OPERATING LEASE: It is a lease other than a finance lease. GROSS INVESTMENT IN THE LEASE is the aggregate of MLPS under a finance lease (fixed payments for a lease term + guaranteed residual value by the lessee) and any unguranteed residual value arising to the lessor. NOTE: Residual value of a leased asset is the estimated fair value of the asset at the end of lease term. NET INVESTMENT IN THE LEASE: It is the gross investment in the lease less unearned finance income. SOME IMPORTANT FORMULAE: 1) Minimum Lease Payments (MLPs) = Total Lease Rentals (excluding Contingent rent, if any) + Residual Value Guaranteed by Lessee to Lessor (GRV) / Purchase Option Price payable by Lessor 2) Unguaranteed Residual Value (URV) = Residual Value of Leased Asset (estimated by the Lessor) GRV 3) Gross Investment in the Lease (GI) = MLPs (in Finance Lease) + URV (if any) 4) Unearned Finance Income (UFI) = GI PV of (MLPs + URV) 5) Net Investment in the Lease (NI) = GI UFI = PV of (MLPs + URV) ACCOUNTING FOR FINANCE LEASES: In the Financial Statements of Lessee: At the inception: Asset on lease Dr [fair value of leased asset] To Lessor However, if fair value exceeds the PV of MLPs from the point of view of lessee, then recording should be done at such PV. Page 1 of 5

EXAMPLE: A machine is acquired on lease on 01.01.2001 for 3 years. The FV of the leases asset on 01.01.01 is Rs.2,35,500.00. Annual lease rentals are Rs.1,00,000.00 payable on 31 Dec. each year. The lessee has guaranteed a residual value of Rs.17000.00 on termination of lease to the lessor. The lessor, however, estimates the salvage value of machinery to be Rs.3,500.00 only on 31.12.03. Interest rate implicit in the lease is the discount rate at which the PV of MLPs + any unguranteed residual value accruing to the lessor becomes equal to the FV of the leased asset. Thus, if we discount 3 annual lease rentals of Rs.1,00,000 and guaranteed residual value Rs.17,000, such that , the aggregate discounted value is equal to FV of Rs.2,35,500.00, the applicable interest rate implicit in the lease comes to 16% Discount Factor PV of MLPs @16% 100000 x 2.246 17000 x 0.641 = 224600 = 10897 235497 approx. RS.235500.00

MLPs = 3 X 100000 + 17000 = 3,17,000 Note: There is no unguaranteed residual value accruing to the lessor. However, if the lessor estimates the salvage value of machine to be Rs.17,000.00 on 31.12.2003 and the lessee guarantees a residual value of Rs.5,000.00 only, then the PV of MLPs from the standpoint of lessee will be Rs.2,27,805.00, which is less than the FV of asset. Hence, the lessee shall record the asset and liability at Rs.227805.00 payment of lease rentals: 31.12.01 Finance Charges Lessor To Bank Finance Charges Lessor To Bank Finance Charges Lessor To Bank Lessor To Bank Dr 37680 Dr 62320 100000 Dr 27709 Dr 72291 100000 Dr 16142 Dr 83858 100000 Dr 17031 17031

31.12.02

31.12.03

Note: Finance charges of 16% p.a. is calculated on outstanding liability. Page 2 of 5

Outstanding liability on 31.12.01 is Rs.235500 Outstanding liability on 31.12.02 is Rs.235500-62320=173180 Outstanding liability on 31.12.03 is Rs.173180-72291=100889 Depreciation on leased asset should be provided on the basis of leased asset should be provided on the basis of AS6. The asset should be fully depreciated over the lease term or its useful life whichever is shorter. Depreciation Dr. To Asset on lease Disclosure Requirements: (a) Assets acquired under finance lease ,as segregated from the assets owned. (b) For each class of assets, the net carrying amount at the balance sheet date. (c) A reconciliation between the total of MLPs at the balance sheet date and their PV. (d) Contingent rents recognized as income in the profit and loss account for the period. (e) The total of future minimum sublease payments expected to be received under non-cancelable sub-lease at the balance sheet date. (f) A general description of the lessees significant leasing agreements. In the Financial Statements of Lessor: At the inception: Lessee Dr. 235500 To Sales 235500 [net investment in lease] Net investment in lease=PV of (MLPs + unguaranteed residual value) Recognition of finance income on receipt of lease rentals periodically: Bank Dr 100000 To Finance Income 37680 To Lessee 62320 And so on. Initial direct cost should be recognized as an expense in the profit and loss account at the inception of lease. Disclosure Requirements: (a) Reconciliation between the gross investment in the lease at the balance sheet date, and the PV of MLPs receivable at the balance sheet date. (b) Unearned finance income. (c) Unguaranteed residual values accruing to the lessor. (d) Accumulated provision for uncollectible mlps receivable. (e) Contingent rents recognized in the profit and loss account for the period. (f) A general description of the significant leasing arrangements of the lessor. (g) Accounting policy adopted in respect of initial direct costs. ACCOUNTING FOR OPERATING LEASES:

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In the Financial Statements of Lessee: Lease payments should be recognised as an expense in the P&L Account, over the lease term, on straight line basis, even if the payments are not on that basis. Disclosure Requirements: (a) Total of future MLPs under non-cancelable operating leases. (b) Total of future MLPs expected to be received under non-cancelable subleases at the balance sheet date. (c) Lease payments recognized in the profit and loss account for the period, with separate amounts for MLPs and contingent rents. (d) Sub-lease payments received/receivable, recognized in the profit and loss account for the period. (e) A general description of the lessees significant leasing arrangements. In the Financial Statements of Lessor: The asset given on lease is shown in the balance sheet of the lessor under FIXED ASSETS Lease income should be recognised on straight-line basis over the lease terms, unless some other systematic basis is more representative of the time pattern in which benefit is derived from the use of the leased asset is diminished. Costs including depreciation incurred in earning the lease income are recognised as expense. Depreciation charge is based on AS 6. Disclosure requirements: (a) For each class of assets, the gross carrying amount, the accumulated depreciation and accumulated impairment losses at the balance sheet date. (b) The future MLPs under non-cancelable operating leases. (c) A general description of the lessors significant leasing arrangements. (d) Total contingent rents recognised in the profit and loss account for the period. (e) Accounting policy adopted in respect of initial direct costs. SALE AND LEASE BACK TRANSACTIONS: Such transactions involve the sale of an asset by the vendor and the leasing of the same asset back to the vendor. If such a transaction results in finance lease, any excess/deficiency of sales proceeds over the carrying amount of asset, should be deferred and amortised over the lease terms in proportion to the depreciation of the leased asset in the financial statements of seller-lessee. Bank/Party Dr. To Sale To Suspense[gain on sale to be deferred] Asset on lease Dr To Party/ lessor If such a transaction results in operating lease, then there may be 3 situations: Page 4 of 5

SITUATION 1: SALE PRICE = FAIR VALUE OF THE ASSET Any profit/ loss on sale should be recognised immediately. SITUATION 2: SALE PRICE < FAIR VALUE Profit/loss on sale should be recognised immediately. However, if the loss on sale is compensated by future lease payments at below market price, then such loss should be deferred and amortised in proportion to the lease payments over the lease period. SITUATION 3: SALE PRICE > FAIR VALUE The excess of selling price over FV should be deferred and amortised over the lease period. If the FV< carrying amount, the asset sold should be written down to fair value and loss recognised immediately.

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An Illustrative Note on Accounting for Leases

(In light of AS 19 issued by ICAI)

This note discusses the accounting aspects of leases by lessors and lessees, under three types of agreements viz., Finance lease, Operating Lease and Sale-Leaseback. KEY POINTS OF THE NOTE: Treatment of unguaranteed residual value at the end of lease term: In the books of lessor, what should be the treatment of balance standing in the Lessees account representing the unguaranteed residual value. This aspect is not detailed in AS 19. This aspect is covered on pg. no.

SOME IMPORTANT FORMULAE: 1) Minimum Lease Payments (MLPs) = Total Lease Rentals (excluding Contingent rent, if any) + Residual Value Guaranteed by Lessee to Lessor (GRV) / Purchase Option Price payable by Lessor 2) Unguaranteed Residual Value (URV) = Residual Value of Leased Asset (Estimated by the Lessor) GRV 3) Gross Investment in the Lease (GI) = MLPs (in Finance Lease) + URV (if any) 4) Unearned Finance Income (UFI) = GI PV of (MLPs + URV) 6) Net Investment in the Lease (NI) = GI UFI = PV of (MLPs + URV) ACCOUNTING FOR FINANCE LEASES: In the Financial Statements of Lessee: At the inception: Asset on lease Dr [fair value of leased asset] To Lessor However, if fair value exceeds the PV of MLPs from the point of view of lessee, then recording should be done at such PV. EXAMPLE: A machine is acquired on lease on 01.01.2001 for 3 years. The FV of the leases asset on 01.01.01 is Rs.2,35,500.00. Annual lease rentals are Rs.1,00,000.00 payable on 31 Dec. each year. The lessee has guaranteed a residual value of Rs.17000.00 on termination of lease to the lessor. The lessor, however, estimates the salvage value of machinery to be Rs.3,500.00 only on 31.12.03. Interest rate implicit in the lease is the discount rate at which the PV of MLPs + any unguranteed residual value accruing to the lessor becomes equal to the FV of the leased asset. Thus, if we discount 3 annual lease rentals of Rs.1,00,000 and Page 6 of 5

guaranteed residual value Rs.17,000, such that , the aggregate discounted value is equal to FV of Rs.2,35,500.00, the applicable interest rate implicit in the lease comes to 16% Discount Factor @16% PV of MLPs 100000 x 2.246 17000 x 0.641 = 224600 = 10897 235497 approx. RS.235500.00

MLPs = 3 X 100000 + 17000 = 3,17,000 Note: There is no unguaranteed residual value accruing to the lessor. However, if the lessor estimates the salvage value of machine to be Rs.17,000.00 on 31.12.2003 and the lessee guarantees a residual value of Rs.5,000.00 only, then the PV of MLPs from the standpoint of lessee will be Rs.2,27,805.00, which is less than the FV of asset. Hence, the lessee shall record the asset and liability at Rs.227805.00 On payment of lease rentals: 31.12.01 Finance Charges Lessor To Bank Finance Charges Lessor To Bank Finance Charges Lessor To Bank Lessor To Bank Dr 37680 Dr 62320 100000 Dr 27709 Dr 72291 100000 Dr 16142 Dr 83858 100000 Dr 17031 17031

31.12.02

31.12.03

Note: Finance charges of 16% p.a. is calculated on outstanding liability. Outstanding liability on 31.12.01 is Rs.235500 Outstanding liability on 31.12.02 is Rs.235500-62320=173180 Outstanding liability on 31.12.03 is Rs.173180-72291=100889 Depreciation on leased asset should be provided on the basis of leased asset should be provided on the basis of AS6. The asset should be fully depreciated over the lease term or its useful life whichever is shorter.

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Depreciation Dr. To Asset on lease In the Financial Statements of Lessor: At the inception: Lessee To Sales

Dr. 2,35,500 2,35,500

[net investment in lease]

Net investment in lease=PV of (MLPs + unguaranteed residual value) However, if the lessor estimates the salvage value to be Rs.17,000 and the lessee guarantees only Rs.5,000, then the entry at the inception will be:

Lessee Dr To Sales To Cost of Sales/Purchases

2,35,500 2,27,805 [Refer Para 34 7,695 of AS 19]

Recognition of finance income on receipt of lease rentals periodically: Bank Dr 1,00,000 To Finance Income 37,680 To Lessee 62,320 And so on. On expiry of lease term, GRV is received: If GRV is Rs.17000 If GRV is Rs 5000 Bank To Lessee Dr 17031 17031 Bank Dr 5000 P&L A/c(URV) Dr 12031 To Lessee 17031

Initial direct cost should be recognized as an expense in the profit and loss account at the inception of lease.

ACCOUNTING FOR OPERATING LEASES: In the Financial Statements of Lessee: Lease payments should be recognized as an expense in the P&L Account, over the lease term, on straight line basis, even if the payments are not on that basis. In the Financial Statements of Lessor: The asset given on lease is shown in the balance sheet of the lessor under FIXED ASSETS Lease income should be recognised on straight-line basis over the lease terms, unless some other systematic basis is more representative of the time pattern in which benefit is derived from the use of the leased asset is diminished. Costs including depreciation incurred in earning the lease income are recognized as expense. Depreciation charge is based on AS 6. Page 8 of 5

SALE AND LEASE BACK TRANSACTIONS: Such transactions involve the sale of an asset by the vendor and the leasing of the same asset back to the vendor. If such a transaction results in finance lease, any excess/deficiency of sales proceeds over the carrying amount of asset, should be deferred and amortized over the lease terms in proportion to the depreciation of the leased asset in the financial statements of seller-lessee. Bank/Party Dr. To Sale To Suspense[gain on sale to be deferred] Asset on lease Dr To Party/ lessor If such a transaction results in operating lease, then there may be 3 situations: SITUATION 1: SALE PRICE = FAIR VALUE OF THE ASSET Any profit/ loss on sale should be recognised immediately. SITUATION 2: SALE PRICE < FAIR VALUE Profit/loss on sale should be recognised immediately. However, if the loss on sale is compensated by future lease payments at below market price, then such loss should be deferred and amortised in proportion to the lease payments over the lease period. SITUATION 3: SALE PRICE > FAIR VALUE The excess of selling price over FV should be deferred and amortized over the lease period. If the FV< carrying amount, the asset sold should be written down to fair value and loss recognized immediately. A Detailed Illustration on Sale-Leaseback: A company sold machinery, whose book value is Rs.12,50,000.00 at a selling price of Rs.10,00,00.00 and leased it back as a capital lease for 20 years. The fair value of the machinery on the date of sale and leaseback is Rs.11, 50,000.00. What will be the accounting treatment of above sale and lease back transaction in the books of seller lease and buyer-lessor? You may make suitable assumptions where necessary.

Solution: Books of seller-lessee: (1)FINANCE LEASEAt the inception: Page 9 of 5

Bank Deferred loss (S&L) To Asset

Dr 10,00,000 Dr 2,50,000 12,50,000

Asset on Lease Dr 11,50,000 To Buyer-Lessor 11,50,000 (Assuming that PV of MLPs from the point of view of lessee is same as F.V.) Annually: Finance Charges Buyer-lessor To Bank Depreciation To Asset (SLM method is used)

Dr Dr

Dr 57,500 57,500

P & L a/c Dr 70,000+ X To Depreciation 57,500 To Deferred loss(S&L) 12,500 To Finance Charges X (Deferred loss should be written off over the lease term in proportion to depreciation of leased asset) (2) OPERATING LEASEAt the inception: Loss On revaluation To Asset P & L a/c To Loss On revaluation Bank P & L a/c / Deferred loss To Asset

Dr 1,00,000 1,00,000 Dr 1,00,000 1,00,000 Dr 10,00,000 Dr 1,50,000 11,50,000

Annually: Lease rentals To Bank

Dr X X

P & L a/c Dr X+7500 To lease Rentals To Deferred Loss a/c ( if any)

X 7500

Books of Buyer Lessor: Page 10 of 5

(1) FINANCE LEASE: At the Inception: Asset/ purchase To Bank Seller-Lessee To Sales/Asset

Dr 10,00,000 10,00,000 Dr 11,50,000 11,50,000

Difference in asset a/c should be amortised over the lease term Annually: Bank To Finance income To seller- lessee (2) OPERATING LEASE: At the Inception: Asset To Bank Annually: Bank To lease rentals Lease rentals To P/L a/c Depreciation To asset P & L a/c To Depreciation

Dr

Dr 10,00,000 10,00,000

Dr

Dr

Dr

Dr

NOTE: The buyer- lessor may revalue its asset upwards by Rs.150000.00 to bring it to its fair value. Such revaluation profit should be deferred in the proportion of depreciation of the asset.

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