AS 19 - Lease Accounting (part 1)

This topic is quite big that's why I have divided it into three parts to help you understand this AS easily and effortlessly.

 

Lease is an agreement;

In that agreement, owner of the asset (Lessor) agrees to transfer to the other party (lessee) in return for periodic payments, the right to use the asset for an agreed period of time.

The lease is of two types:

1)      Operating lease and 2) finance lease.

Finance lease:

The lease is called Finance lease if it transfers substantially all the risk and reward incident to the ownership of an asset to the lessee. Title may or may not eventually be transferred.

Situations that lead to finance lease:

ü  The lease transfers ownership of the asset to the lessee by the end of the lease term.

ü  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 certain that option will be exercised.

ü  The lease term is for the major part (75% approx) of the economic life of the asset. At the commencement of this lease, the PV of minimum lease payments should be substantial (90% approx) of the fare value of the asset.

PV of minimum lease payments= pv of {all the installments amount (+) guaranteed residual value} of the asset.

Indicator of finance lease:

ü  If the lessee cancels the lease agreement then the lessor’s loss will be borne by lessee.

ü  Gains or loss resulting from the fluctuation in fair value of the asset fall to the lessee.

 

 

Implicit rate of interest: it’s the interest rate that is included or hidden in the installment amount.

Suppose, the installment amount of an asset in lease, is 50000 per year. Now this 50000 include principal amount and interest amount. This interest amount has been charged according to some specific interest rate, this interest rate is called implicit rate of interest.

ACCOUNTING FOR FINANCE LEASE (in the books of lessee):

 At the commencement of the lease agreement, Lessee will record an item as an asset in the balance sheet and lessor’s a/c as liability. The amount will be lower of fair value or PV of minimum lease payment. The initial direct cost related to the finance lease will be added to the amount of the asset.

Minimum lease payment=installment amount + GR.

Following steps are to be followed in finance lease in the lessee’s book:

Step 1: determine the implicit rate by trial and error method.

Step 2: use that implicit rate to determine the PV of MLP.

Step 3: check which one is lower between A) fare value of the asset (suppose 3lakh) and B) PV of MLP (suppose 2.90lakh).

Step 4: pass the entry, Asset a/c         Dr

                                                To lessor a/c.(amt. should be 2.90lakh)

Step 5: determine the finance charge that is interest amount each year. You can derive it just by using implicit rate of interest on the principal amount derived in step 4 that is 2.90lakh.

Step 6: pass the entry,1) finance charge a/c…….dr to lessor a/c (due entry), 2) lessor a/c …dr to bank (payment entry), 3)P/L account…….dr to finance charge.

Step 7: pass one more entry, lessor a/c………dr to bank..(Principal amount of the year which were included in the lease installment paid)

To understand step 7 we need to elaborate our example.

Suppose the implicit rate we determined= 10%.

Lease installment= 80000 at the end of each year, lease period= 5 years.

Fair value= 3lakh, PV OF MLP=2.90LAKH,

Asset is valued in the balance sheet of lessee obviously 2.90lakh.

Now the finance charge in the first year is 29000.(see step 5)

Principal amount of 1st year, (see step 7) = 80000-29000=51000.

In 2^nd year the finance charge will be 290000-51000=239000*10%=23900.

Principal amount in 2^nd year=80000-23900=56100.

In 3^rd year the finance charge will be 239000-56100=182900*10%=18290.

Principal amt. in 3^rd year will be 80000-18290=61710….

So it will continue like this.

Now we can see that once the implicit rate of interest is determined the rest of the work is pretty simple but the question arises here is how to determine the implicit rate of interest?..here it is..

ANS: In finance lease, fair value= PV of minimum lease payments + PV of UGR.

It means the interest rate by which PV of MLP and UGR is equal to FAIR VALUE of the asset, is called the implicit rate of interest. For this we have to choose random interest like 10%, or 14 %, or 8%, and we have to see whether it match with fair value or not, this is called trial and error method.

But if UGR (unguaranteed residual value) is absent; implicit rate will not be applicable instead of this, borrowing rate of interest is to be followed to determine the PV of MLP and check the lower between fair value and PV of MLP. If the lower is fair value then again discounting factor is needed to determine finance charge by trial and error method.

Initial direct cost will be added to the cost of asset in balance sheet.

Depreciation of the leased asset:

Depreciation should be calculated according to AS 6. If there is uncertainty that whether or not the lessee will get ownership of the asset by the end, depreciation will be charged according to the estimated life of the asset or leased life whichever is shorter. Journal entry will be :

 P/L a/c       Dr 

        To depreciation a/c

Disclosure made by the lessee:

Apart from the requirement of AS 6 and AS 10 the lessee is required to disclose for finance lease:

1)      Asset acquired under finance lease should be segregated from asset owned.

2)      For each class of asset, the net carrying amount at the balance sheet date.

3)      Reconciliation between total of MLP and its present value. In addition, the enterprise should disclose the total of MLP and its present value for each of the following period:

Not later than 1 year---later than 1 year but not more than 5 year---later than 5 year.

4)      Contingent rent should be recognized as expense in the statement of profit and loss account.

5)      Total of future MLP expected to receive from sublease at the balance sheet.

Accounting for finance lease (lessor’s books):

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

GIL=Gross investment in lease=Total installment payments (+) Guaranteed residual value (+) Unguaranteed residual value.

Fair value= pv of MLP + pv of UGR=pv of GIL.

GIL (-) fair value = unearned finance income.

GIL(-) UNEARNED FINANCE INCOME=NET INVESTMENT IN LEASE=FAIR VALUE.

At the inception of lease the journal entry will be:

1)      Lessee a/c         Dr

            To  bank a/c         (if lessor purchase the asset for lease purpose)

2)      Lessee a/c         Dr

              To  sales a/c           (if lessor is a manufacturer or dealer)

In the first case only unearned finance income will be recognized and apportioned according to the lease period

In the second case, lessor earns the profit in two ways..1) GIL(-)FAIR VALUE/ SALES VALUE and 2) FAIR VALUE(-)COST.

Fair value (-) cost is interpreted as sales revenue and cost, and they will be recorded in the statement of profit and loss account.

Similarly the finance income will be recorded in the P/L as income.

Contingent rent, fees for services, and taxes recovered from lessee are recognize as income as and when accrue and initial direct cost will be recognize as expense in the statement of profit and loss account at the inception of lease.

Revision in the UGR---when the UGR in any year is revised the finance income allocation over the remaining lease term is to be revised.

Disclosure:

ü  Reconciliation between total gross investment and the pv of MLP receivable at the balance sheet date.

ü  Disclosure of total gross investment In lease and the pv of MLP receivable at the balance sheet date for each of the following period; not later than 1 year, between 1 to 5 year and later than 5 year.

ü  Unearned finance income.

ü  UGR accruing to the benefit of lessor.

ü  Accounting policy adopted in case of initial direct cost.

ü  Contingent rent recognize in the statement of profit and loss account.

If you have any query regarding this part, feel free to write in comment box below.