AS 19 Lease Accounting

Table of contents

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Lease Accounting

A lease is an agreement which is entered into by the owner of an asset (lessor) with the intended user of the asset (lessee) in return for a payment or series of payments for an agreed period of time. It is a transaction which gives the lease the right to use an asset for a specified period of time.

It is to ne noted here that the definition of a lease includes agreements for the hire of an asset which contain a provision giving the hirer an option to acquire title to the asset upon the fulfillment of agreed conditions. These agreements are commonly known as hire purchase agreements.

In India, accounting for leases is covered under Accounting Standard (AS) 19 Leases.

Objective

The objective of AS 19 is to prescribe the appropriate accounting policies and disclosures in relation to finance leases and operating leases for both lessees and lessors.

Applicability

AS 19 should be applied in accounting for all leases other than:

1. lease agreements to explore for or use natural resources, such as oil, gas, timber, metals and other mineral rights;
2. licensing agreements for items such as motion picture films, video recordings, plays, manuscripts, patents and copyrights; and
3. lease agreements to use lands.

Important Definitions

The following terms are used in this Standard with the meanings specified:

A lease 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.

A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset.

An operating lease is a lease other than a finance lease.

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.

The inception of the lease 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. 

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.

Minimum lease payments are the payments over the lease term that the lessee is, or can be required, to make excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:

(a) in the case of the lessee, any residual value guaranteed by or on behalf of the lessee; or 
(b) in the case of the lessor, any residual value guaranteed to the lessor: 

1. 1. by or on behalf of the lessee; or
   2. by an independent third party financially capable of meeting this guarantee. However, if the lessee has an 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 that, at the inception of the lease, is reasonably certain to be exercised, the minimum lease payments comprise minimum payments payable over the lease term and the payment required to exercise this purchase option.

Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.

Economic life is either: (a) the period over which an asset is expected to be economically usable by one or more users; or (b) the number of production or similar units expected to be obtained from the asset by one or more users.

Useful life of a leased asset is either: (a) the period over which the leased asset is expected to be used by the lessee; or (b) the number of production or similar units expected to be obtained from the use of the asset by the lessee.

Residual value of a leased asset is the estimated fair value of the asset at the end of the lease term.

Guaranteed residual value is:

(a) in the case of the lessee, that part of the residual value which is guaranteed by the lessee or by a party on behalf of the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable); and
(b) in the case of the lessor, that part of the residual value which is guaranteed by or on behalf of the lessee, or by an independent third party who is financially capable of discharging the obligations under the guarantee.

Unguaranteed residual value of a leased asset is the amount by which the residual value of the asset exceeds its guaranteed residual value.

Gross investment in the lease is the aggregate of the minimum lease payments under a finance lease from the standpoint of the lessor and any unguaranteed residual value accruing to the lessor.

Unearned finance income is the difference between:

(a) the gross investment in the lease; and 
(b) the present value of (i) the minimum lease payments under a finance lease from the standpoint of the lessor; and (ii) any unguaranteed residual value accruing to the lessor, at the interest rate implicit in the lease.

Net investment in the lease is the gross investment in the lease less unearned finance income.

The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments under a finance lease from the standpoint of the lessor; and (b) any unguaranteed residual value accruing to the lessor, to be equal to the fair value of the leased asset.

The lessee’s incremental borrowing rate of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset.

Contingent rent is that portion of the lease payments that is not fixed in amount but is based on a factor other than just the passage of time (e.g., percentage of sales, amount of usage, price indices, market rates of interest).

Classification of Leases

The classification of leases is based on the extent to which risks and rewards incident to ownership of a leased asset lie with the lessor or the lessee.

Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return due to changing economic conditions. Rewards may be represented by the expectation of profitable operation over the economic life of the asset and of gain from appreciation in value or realisation of residual value.

Leases are classified into two types:

1. Finance lease: A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. Title may or may not eventually be transferred.
2. Operating lease: A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incident to ownership.

It is important to note that lease classification is made at the inception of the lease. If at any time the lessee and the lessor agree to change the provisions of the lease, other than by renewing the lease, in a manner that would have resulted in a different classification of the lease the revised agreement is considered as a new agreement over its revised term. However, Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased asset) or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes.

1. Finance Lease

Finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than its form.

Situations which lead to a lease being classified as a finance lease

(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.

Indicators of situations leading to finance lease

(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.

Treatment of finance lease in financial statement of lessee

Treatment of finance lease transactions is very significant bcoz if such transactions are not reflected in the lessee’s balance sheet, the economic resources and the level of obligations of an enterprise are understated thereby distorting financial ratios. It is therefore appropriate that a finance lease be recognised in the lessee’s balance sheet both as an asset and as an obligation to pay future lease payments.

Recognition of finance lease by lessee: At the inception of the lease, the asset and the liability for the future lease payments are recognised in the balance sheet at the same amounts.

Such recognition should be at an amount equal to the fair value of the leased asset at the inception of the lease. However, if the fair value of the leased asset exceeds the present value of the minimum lease payments from the standpoint of the lessee, the amount recorded as an asset and a liability should be the present value of the minimum lease payments from the standpoint of the lessee.

In calculating the present value of the minimum lease payments the discount rate is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate should be used.

Lease payments should be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge should be allocated to periods during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period.

Finance lease and Depreciation: A finance lease gives rise to a depreciation expense for the asset as well as a finance expense for each accounting period. The depreciation policy for a leased asset should be consistent with that for depreciable assets which are owned. If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset should be fully depreciated over the lease term or its useful life, whichever is shorter.

Disclosure of financial lease by lessee:

The lessee should, in addition to the requirements of AS 10, Accounting for Fixed Assets, AS 6, Depreciation Accounting, and the governing statute, make the following disclosures for finance leases:

(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 minimum lease payments at the balance sheet date and their present value. In addition, an enterprise should disclose the total of minimum lease payments at the balance sheet date, and their present value, for each of the following periods: (i) not later than one year; (ii) later than one year and not later than five years; (iii) later than five years;

(d) contingent rents recognised as expense in the statement of profit and loss for the period;

(e) the total of future minimum sublease payments expected to be received under non-cancellable subleases at the balance sheet date; and

(f) a general description of the lessee’s significant leasing arrangements including, but not limited to, the following: (i) the basis on which contingent rent payments are determined; (ii) the existence and terms of renewal or purchase options and escalation clauses; and (iii) restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.

Provided that a Small and Medium Sized Company, as defined in the Notification, may not comply with sub paragraphs (c), (e) and (f).

Treatment of finance lease in financial statement of lessor

Recognition of finance lease by lessor: The lessor should recognise assets given under a finance lease in its balance sheet as a receivable at an amount equal to the net investment in the lease.

The recognition of finance income should be based on a pattern reflecting a constant periodic rate of return on the net investment of the lessor outstanding in respect of the finance lease.

Disclosure of financial lease by lessor:

The lessor should make the following disclosures for finance leases:

1. a reconciliation between the total gross investment in the lease at the balance sheet date, and the present value of minimum lease payments receivable at the balance sheet date. In addition, an enterprise should disclose the total gross investment in the lease and the present value of minimum lease payments receivable at the balance sheet date, for each of the following periods: (i) not later than one year; (ii) later than one year and not later than five years; (iii) later than five years;
2. unearned finance income;
3. the unguaranteed residual values accruing to the benefit of the lessor;
4. the accumulated provision for uncollectible minimum lease payments receivable;
5. contingent rents recognised in the statement of profit and loss for the period; 
6. a general description of the significant leasing arrangements of the lessor; and
7. accounting policy adopted in respect of initial direct costs.

Provided that a Small and Medium Sized Company, as defined in the Notification, may not comply with subparagraphs (a) and (f).

2. Operating Lease

Operating lease is a lease other than a finance lease.

Treatment in financial statement of lessee

Recognition of operating lease:

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.

Disclosure of operating lease:

The lessee should make the following disclosures for operating leases:

1. the total of future minimum lease payments under noncancellable operating leases for each of the following periods: (i) not later than one year; (ii) later than one year and not later than five years; (iii) later than five years;
2. the total of future minimum sublease payments expected to be received under non-cancellable subleases at the balance sheet date;
3. lease payments recognised in the statement of profit and loss for the period, with separate amounts for minimum lease payments and contingent rents;
4. sub-lease payments received (or receivable) recognised in the statement of profit and loss for the period;
5. a general description of the lessee’s significant leasing arrangements including, but not limited to, the following: (i) the basis on which contingent rent payments are determined; (ii) the existence and terms of  renewal or purchase options and escalation clauses; and (iii) restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.

Provided that a Small and Medium Sized Company, as defined in the Notification, may not comply with subparagraphs (a), (b) and (e).

Treatment in financial statement of lessor    

Recognition of operating lease:

The lessor should present an asset given under operating lease in its balance sheet under fixed assets.

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.

Operating lease and Depreciation: The depreciation of leased assets should be on a basis consistent with the normal depreciation policy of the lessor for similar assets, and the depreciation charge should be calculated on the basis set out in AS 6, Depreciation Accounting.

Disclosure of operating lease:

The lessor should, in addition to the requirements of AS 6, Depreciation Accounting and AS 10, Accounting for Fixed Assets, and the governing statute, make the following disclosures for operating leases:

1. for each class of assets, the gross carrying amount, the accumulated depreciation and accumulated impairment losses at the balance sheet date; and (i) the depreciation recognised in the statement of profit and loss for the period; (ii) impairment losses recognised in the statement of profit and loss for the period; (iii) impairment losses reversed in the statement of profit and loss for the period;
2. the future minimum lease payments under non-cancellable operating leases in the aggregate and for each of the following periods: (i) not later than one year; (ii) later than one year and not later than five years; (iii) later than five years;
3. total contingent rents recognised as income in the statement of profit and loss for the period;
4. a general description of the lessor ’s significant leasing arrangements; and
5. accounting policy adopted in respect of initial direct costs.

Provided that a Small and Medium Sized Company, as defined in the Notification, may not comply with subparagraphs (b) and (d).

Sale and Leaseback Transactions

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 lease payments and the sale price are usually interdependent as they are negotiated as a package.

Accounting of sale and leaseback transaction

The accounting treatment of a sale and leaseback transaction depends upon the type of lease involved.

When a sale and leaseback transaction results in a finance lease: Any excess or deficiency of sales proceeds over the carrying amount should not be immediately recognised as income or loss in the financial statements of a seller-lessee. Instead, it should be deferred and amortised over the lease term in proportion to the depreciation of the leased asset.

When a sale and leaseback transaction results in an operating lease: In such a case, if it is clear that the transaction is established at fair value, any profit or loss should be recognised immediately. If the sale price is  below fair value, any profit or loss should be recognised immediately except that, if the loss is compensated by future lease payments at below market price, it should be deferred and amortised in proportion to the lease payments over the period for which the asset is expected to be used. If the sale price is above fair value, the excess over fair value should be deferred and amortised over the period for which the asset is expected to be used.

For operating leases, if the fair value at the time of a sale and leaseback transaction is less than the carrying amount of the asset, a loss equal to the amount of the difference between the carrying amount and fair value should be recognised immediately. For finance leases, no such adjustment is necessary unless there has been an impairment in value, in which case the carrying amount is reduced to recoverable amount in accordance with the Accounting Standard dealing with impairment of assets.

Illustration 1
 Arun Ltd. has taken an equipment on operating lease for the coming 5 years. As per the agreement with the lessor, it will not make any payment for lease rentals for the first 2 years, and will have to pay ₹ 21,00,000 in each of the following 3 years. Advise Arun Ltd. on accounting for the lease rentals in this case.

Solution:

As per AS-19, 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. The pattern of payment, in this case, does not follow straight line basis, rather it is arising towards the end of the lease period. For accounting purpose, such effect should be neutralized i.e. the total payment of ₹ 63,00,000 in 
the last 3 years should be spread over the entire lease period of 5 years i.e. ₹ 12,60,000 should be charged to the statement of profit and loss for each year.

Illustration 2

Vishnu Ltd. leased a printing machine from Garur Ltd. for a period of 3 years. The useful life of the printing machine is known to be of 5 years. It was agreed between the lessor and lessee that the amount will be paid in 3 instalments and at the termination of the lessee, Garur Ltd. will take back the said machine. The following details are available in respect of the machine lessee:

• Cost of the printing machine is ₹ 15,00,000;
• Unguaranteed residual value at the end of the lease period is ₹ 2,00,000;
• Fair value of the machine is ₹ 15,00,000;
• The internal rate of return of the investment is 10%.
  You are required to:
  (a) State whether the lease is a finance lease or an operating lease?
  (b) Ascertain the amount of unearned finance income.
  Given: PVF10%, 3 = 0.7513; PVAF10%, 3 = 2.4868.

Solution:
(a) Present value of unguaranteed residual value = ₹ 2,00,000 × 0.7513 = ₹ 1,50,260

⸫ Present value of lease payments = ₹ (15,00,000 – 1,50,260) = ₹ 13,49,740

Present value of lease payments as percentage of Fair value =  13,49,740 / 15,00,000  = 90% (approx.)

As the ‘Present value of lease payments’ makes a substantial portion of the ‘Fair value’, the machine lease by Vishnu Ltd. from Garur Ltd. is a finance lease by nature.

(b) Annual lease payments =  Present value of lease payments / PVAF10%, 3 =  13,49,740 / 2.4868  = ₹ 5,42,762  (approx.)

Gross investment in lease = ₹ [(₹ 5,42,762 × 3) + 2,00,000] = ₹ 18,28,286

⸫ Unearned finance income = Excess of ‘Gross investment in lease’ over ‘Cost of the printing machine’

  = ₹ (18,28,286 – 15,00,000)

  = ₹ 3,28,286

Exercise 

A. Theoretical Questions:

Multiple Choice Questions

1. The person who undertake an agreement, conveys to another person the right to use in return for rent, an assest for an agreed period of time.
   a. Lessor
   b. Lessee
   c. Both
   d. None of the above
2. Operating lease is a _________ .
   a. Revocable contract
   b. Non revocable contract
   c. Operating contract
   d. None of the above
3. Which lease transfer substantially all the risk and rewards incident to ownership of an asset?
   a. Operating lease
   b. Finance lease
   c. Both
   d. None of the above
4. In which types of lease expenses like maintenance, repair, and taxes are born by the lessor?
   a. Operating lease
   b. Financial lease
   c. Both
   d. None of the above
5. Short-term lease which is often cancellable is known as
   a.  Finance Lease
   b.  Net Lease
   c.  Operating Lease
   d.  Leverage Lease
6.  A lease which is generally not cancellable and covers full economic life of the asset is known as:
   a.  Sale and leaseback
   b.  Operating Leasec.
   c.  Finance Lease
   d. Economic Lease
7. One difference between Operating and Financial lease is:
   a. There is often an option to buy in operating lease
   b. There is often a call option in financial lease.
   c. An operating lease is generally cancelable by lease
   d. A financial lease in generally cancelable by lease.

Solution:

1

a

2

a

3

b

4

a

5

c

6

c

7

c

B. Numerical Questions:

CMA book unsolved questions solution

Unique Ltd. availed a lease from Papan Ltd. on following terms:

• A lease for a tenor of 3 years, in the beginning of year 2020 for equipment costing ₹ 7,00,000 and which has an expected useful life of 5 years. The fair market value is also ₹ 7,00,000.
• 3 equal annual payments are made at end of each year.
• The property reverts back to the lessor on termination of the lease.
• The unguaranteed residual value is estimated at ₹ 75,000 at the end of year 2022.
• IRR=10%
• The present value of ₹ 1 due at the end of 3rd year at 10% rate of interest is 0.7513.
• The present value of annuity of ₹ 1 due at the end of 3rd year at 10% IRR is ₹ 2.4868

(i) State with reason whether the lease constitute finance lease.

(ii) Calculate unearned finance income. 

Solution: