Question

Two common types of leases are operating and financing leases. In your own words, describe and share examples of each. What are the major differences in accounting for each of these two types of leases?

Answer 1

(i) Finance leases; and

(ii) Operating leases.

A Finance Lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not be eventually transferred. A lease is classified as an Operating Lease if it does not transfer substantially all the risk and rewards incident to ownership.

Indicators of Finance Lease

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, 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.

Operating Lease : -

It is a lease which does not transfer substantially all the risk and rewards incidental to ownership.Operating leases are non-payout leases, i.e. an individual contract of operating lease does not usually recover the entire cost of leased asset for the lessor. Lease payments under an operating lease should be recognised as an expense in the statement of profit and loss of a lessee 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.

Accounting for Finance Leases (Books of lessee)

Following is the accounting treatment of Finance Leases in the books of Lessee:

(i) On the date of inception of Lease, Lessee should show it as an asset and corresponding liability at lower of:

· Fair value of leased asset

· Present value of minimum lease payments (present value to be calculated with discount rate equal to interest rate implicit in the lease)

(ii) Lease payments to be apportioned between the finance charge and the reduction of the outstanding liability.

(iii) Finance charges to be allocated to periods during the lease term so as to produce a constant rate of interest on the remaining balance of liability for each period.

(iv) Charge depreciation on leased asset on the same lines as any other asset. If there is not certainity that the lessee will obtain ownership by the end of the lease term, the asset should be fully depreciated over the lease term.

Accounting for finance leases (Books of lessor)

In a finance lease, the lessee effectively buys the leased asset sold by the lessor. The lessor recognises the net investment in lease (which is usually equal to fair value, i.e. usual market price of the asset, as shown below) as receivable by debiting the Lessee A/c. Where the lessor pays to purchase the asset for giving on finance lease, the corresponding account credited is Bank. Where the lessor is a manufacturer or dealer, the corresponding account credited is Sales. In the later case, the difference between the sale value recognised and cost of the asset gets recognised as profit / loss on transfer to the statement of profit and loss of the period of inception of lease

Gross investment in Lease (GIL)

= Minimum Lease Payments (MLP) + Unguaranteed Residual value (UGR) Minimum Lease Payments

Minimum Lease Payments (MLP) are the payments that the Lessee is to make to the Lessor, together with:

(i) in the case of the lessee, any residual value guaranteed by or on behalf of the lessee; or

(ii) in the case of the lessor, any residual value guaranteed to the Lessor:

· by or on behalf of the lessee;or

· by an independent third party financially capable of meeting the gurantee

Unguaranteed Residual Value

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

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.

Net investment in Lease (NIL)

= Gross investment in Lease (GIL) – Unearned Finance Income (UFI).

Unearned finance income (UFI) = GIL – (PV of MLP + PV of UGR)

The discounting rate for the above purpose is the rate of interest implicit in the lease. From the definition of interest rate implicit on lease:

(PV of MLP + PV of UGR) = Fair Value.

The above definitions imply that:

(a) Unearned Finance Income (UFI) = GIL – Fair Value

(b) Net Investment in Lease = GIL – UFI = GIL – (GIL – Fair Value) = Fair Value

Since the sale and receivables are recognised at net investment in lease, which is equal to fair value: Profit recognised at the inception of lease = Fair Value – Cost

Total earning of lessor = GIL – Cost

= (GIL – Fair Value) + (Fair Value – Cost)

= Unearned Finance Income + (Fair Value – Cost)

The above analysis does not hold where the discounting rate is not equal to interest rate implicit on lease. Such is the case, where the interest rate implicit on lease is artificially low. As per paragraph 32, the discounting rate in such situations should be the commercial rate of interest.

Recognition of Finance Income

The unearned finance income is recognised over the lease term on a systematic and rational basis. This income allocation is based on a pattern reflecting a constant periodic return on the net investment in lease outstanding.

The constant periodic return is the rate used for discounting, i.e. either the interest rate implicit on lease or the commercial rate of interest.

Accounting for Operating Leases

Operating leases are non-payout leases, i.e. an individual contract of operating lease does not usually recover the entire cost of leased asset for the lessor. Lease payments under an operating lease should be recognised as an expense in the statement of profit and loss of a lessee 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.

Accounting treatment in the Books of lessee

Lease payments are frequently tailor made to suit the payment capacity of the lessee. For example, a lease term may provide for low initial rents and high terminal rent. Such payment patterns do not reflect the pattern of benefit derived by the lessee from the use of leased asset. To have better matching between revenue and costs, paragraph 23 of the standard requires lessees to recognise operating lease payments as 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.

Accounting treatment in the books of lessor

(i) It requires a lessor to treat assets given under operating leases as fixed assets in its balance sheets and

(ii) It requires depreciation to be recognized in the books of lessor. 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 10.

(iii) The impairment losses on assets given on operating leases are determined and treated as per AS 28.

A manufacturer or dealer lessor should bring the asset given on operating lease as fixed asset in their books by debiting concerned Fixed Asset A/c and crediting Cost of Production / Purchase at cost. No selling profit should be recognised on entering into operating lease, because such leases are not equivalents of sales

Eg : -

1 - Lessee has option to purchase the asset at lower than fair value, at the end of lease term - Finance lease

2 -

An equipment having expected useful life of 5 years, is leased for 3 years. Both the cost and the fair value of the equipment are ` 6,00,000. The amount will be paid in 3 equal installments and at the termination of lease, lessor will get back the equipment. The unguaranteed residual value at the end of 3rd year is ` 60,000. The IRR of the investment is 10%. The present value of annuity factor of ` 1 due at the end of 3rd year at 10% IRR is 2.4868. The present value of ` 1 due at the end of 3rd year at 10% rate of interest is 0.7513. State with reason whether the lease constitutes finance lease and also compute the unearned finance income.

(i) Determination of Nature of Lease

It is assumed that the fair value of the leased equipments is equal to the present value of minimum lease payments.

Present value of residual value at the end of 3rd year           = 60,000 x 0.7513= 45,078

Present value of lease payments                                           = 6,00,000 – ` 45,078= 5,54,922

The percentage of present value of lease payments to fair value of the equipment is

= (5,54,922 / 6,00,000) x 100 = 92.487%.

Since, it substantially covers the major portion of the lease payments, the lease constitutes a finance lease.

1. Calculation of Unearned Finance Income

Annual lease payment =5,54,922 / 2.4868 =2,23,147 (approx)

Gross investment in the lease = Total minimum lease payment + unguaranteed residual value

= (2,23,147 × 3) + 60,000 = 6,69,441 +60,000 = 7,29,441

Unearned finance income = Gross investment - Present value of minimum lease payments and unguaranteed residual value

= 7,29,441 – 6,00,000 =1,29,441