Indian leasing by Vinod Kothari
Accounting for Lease and hire-purchase
1.Why specific method of accounting for lease transactions:
Accounting for lease transactions is an international issue - accountants have been concerned about a proper method of lease accounting for almost 50 years now.
The concern springs up from the essential accounting rule that transactions ought to be recorded as per their intrinsic substance, and not merely based on their legal form. The legal form of every lease transaction is an asset renting transaction. However, in substance, many lease transactions, particularly financial lease transactions, create for the lessee an interest in an asset almost similar to bought assets, and a liability to pay to the lessor almost similar to those in a loan transaction. Similarly, for the lessor, though he apparently receives a rental income, the substance of his receipts is closer to recovery of principal and interest on outstanding principal, then an income by hiring out assets.
Thus, accounting standards on lease accounting are concerned with (a) distinguishing leases between financial transactions and asset-renting transactions based on the substance of the lease; and (b) having found the substance, in applying a finance-based accounting if the substance is found to be a financial transaction, and an asset-renting based accounting, if the substance is not plain financing. Click here for more on the substance of a financial lease.
This is the essence of accounting standards on leasing in most countries - the basic approach underlying FASB-13 (USA), or IAS-17 (International Accounting Standards Committee) or SSAP-21 (UK), is this.
Recently, however, McGregor has made a proposal for eliminating the present distinction between financial and operating leases and putting operating leases also as if it were an asset of the user. Click here for an article on these proposals and the proposed changes in IAS-17 based on McGregor's paper.
2. Indian and international accounting standards compared:
International accounting standards adopt what is known as finance accounting approach to financial lease transactions. That is, based on the substance of the transaction, a financial lease is recorded as a financing transaction both in the books of the lessor and the lessee. The lessee will accordingly capitalize the asset though the lessor owns it. The lessee will also record a corresponding liability for payments to the lessor, as if it were a loan not lease. The lessor will bifurcate rentals into principal and interest, and take only the latter as his income. The lessee will also expense the same.
While the international accounting standards were concerned about the distortions that would be caused on the lessee's financial statements if financial leases were not recorded in the above manner, in India, the concern was essentially the lessor's financial statements. The distortions in lessor's reported income - that was the chief issue in India, which is understandable in view of the low penetration ratios of leasing as a percentage of total industrial assets at that time.
Hence, Indian accounting standard did not make any substantial change to the way a lessee will account for a lease - in other words, leaving lessee's accounting virtually untouched, it made provisions only for the lessor's accounting.
Thus, in India:
The Guidance Note on Lease Accounting adopts the full payout test for differentiating between a financial and operating lease. It may be noted that international accounting standards distinguish between a lease and a financing transaction based on the substance of the lease. If substantively, all the risks and rewards incident to ownership of an asset are transferred to the lessee, the lease is taken as a financial transaction. Besides this general test, there are 4 quantitative tests:
McGregor's paper has sought to expand this list of quantitative tests further - click here for an independent article on the issue.
The applicability of these tests to India should be understood clearly. Indian Guidance Note has only adopted the full payout test. The first two tests above, that is, transfer of title or bargain purchase option will re-characterise the lease as a hire-purchase or conditional sale. In that case, the applicable accounting standard is completely different - see below or click here.
The lease term test is too subjective as it depends upon a subjective assessment of the life of the asset, which, except for very clear cases of fast technological obsolescence, may be difficult to apply with definitiveness in any case.
So for all practical purposes, international accounting standards and Indian Guidance Note both hinge heavily on the full payout test.
To apply the full payout test, one has to take the discounted value of (a) minimum or assured lease rentals and (b) assured residual value. If the sum of the two covers the whole or substantially the whole of the cost of the asset, then the lease is a financial lease.
There are two tricky issues here - one is the discounting rate, and second is the tax benefits.
Though both the Guidance Note and the IAS-17 are not clear on what is the appropriate discounting rate for minimum lease payments, the rate should certainly not be the IRR of the transaction, because at that rate, by definition, the minimum lease rentals will be equal to the initial cost of the asset. Appropriately the rate should be the normal rate of investment in a usual financial transaction, or the average pre-tax rate of return of the lessor.
The cost of the asset becomes a critical issue in case of transactions which are motivated by tax benefits as their sole or principal attraction. For example, there are certain assets eligible for 100% depreciation. [Click here for a table containing tax depreciation rates]. In such cases, the cost of the asset has to be ascertained after giving effect to the benefit of accelerated depreciation. Though this is not quite easy, the only feasible way is to apply the full payout test on a post-tax basis in such cases.
The essence of the Guidance Note as also the international accounting standards is the bifurcation of rentals into return on the investment made in the transaction, and repayment of the same. The repayment part, called Capital Recovery, cannot be said to be "income" in the accounting sense, therefore, the objective of the accounting method is to eliminate from the income statement so much of the rentals as represent the capital recovery portion.
The rentals may be split into (a) finance charges; and (b) capital recovery either based on the sum of digits method or based on the IRR or actuarial method. The former method is briefly discussed below.
The IRR method determines the financial income and repayment of principal based on the actual rate of return inherent in the rentals. The actual or implicit rate of return is mathematically arrived at first. In general, this rate of return is the pre-tax rate of return, except in case of tax-oriented transactions as mentioned above.
Having determined the IRR, computation of finance charges is plain mathematics - taking the initial investment as the basis, the IRR is applied to get the finance charges in the first rental period. The balance of the rentals is capital recovery which reduces the investment in the next period, and so on.
5. Examples on splitting of rentals into capital recovery and finance charges:
Click here to view examples on computation of finance charges and capital recovery.
There are 5 examples taken with various assumptions - rentals in arrears, rentals in advance, rent with security deposit, rent with residual value, security deposit bearing interest, etc.
6. Lease equalisation account:
The concept of lease equalisation account is an equaliser between the capital recovery inherent in lease rentals and the depreciation chargeable as per Companies Act.
The concept of lease equalisation is a necessary successor to the capitalisation of the asset by the lessor. As the lessor capitalises the asset, he has to charge off depreciation in books. This depreciation is as per the prescribed rates of book depreciation under the Companies Act.
However, the objective of the lessor is to write-off an amount equal to the capital recovery inherent in lease rentals, so as to leave in the revenue statement only the financing charges.
Therefore, the difference between capital recovery and book depreciation is transferred to the Lease equalisation account, which in the revenue statement is an addition to, or deduction from rentals. See in the Examples given above.
In the Balance Sheet, the lease equalisation account is carried as the lease terminal adjustment account (LTA) and is deducted from/added to the written down value of the fixed asset.
Essentially, therefore, the depreciation every year plus/minus lease equalisation account shall be equal to the capital recovery portion of lease rentals, and the accumulated depreciation plus/minus lease terminal account is equal to the aggregate capital recovered. Thus, the revenue taken in books is set equal to the financing income featuring in rentals, and the balance sheet value of the asset is equal to the capital yet to be recovered, or outstanding principal, or the present value of future rentals.
One could ask - what is the grand idea of splitting capital recovery into book-keeping depreciation and lease equalisation? Why not take the capital recovery itself as depreciation? Well, the only objective is to seem to be complying with the usual book depreciation rules, without actually complying with the same.
There is not much in the Guidance Note on lessee disclosures. This is markedly different from international accounting standards, which are essentially focused on lessee's disclosure requirement. The apparent reason for this was discussed above.
The only requirement for lessee's disclosure is that the lessee will reflect, by way of a note on the balance sheet, the commitments on account of lease rentals. The requirement should be understood as disclosure of capitalised value of future lease rentals, that is, the principal outstanding inherent in future rentals.
There is something on accounting for rentals - this is in line with IAS-17, relating to operating leases. If the rentals are structured, that is, not uniform, then the annual charge needs to be worked out based on a reasonable basis, such as use of the asset, wear and tear, etc.
8. Accounting for operating leases:
There is scarce little in accounting standards, either Indian accounting standards or the International accounting standards, on operating leases, though McGregor study [click here for an article on this] now intends to put operating leases at par with financial leases.
Operating lease rentals will be taken as income to revenue statement. The asset will be depreciated by the lessor as per the regular depreciation policy. Regular depreciation rules are given in the Companies Act - sec. 205 (2) read with Schedule XIV. A company may choose either the straight line depreciation policy or written value method. The rates are laid down in law, and these are the minimum rates.
9. Accounting for hire-purchase transactions:
While International accounting standards do not make any distinction between financial leases and hire-purchase transactions ( a lease with an option to buy is regarded as financial lease), the Guidance Note on lease accounting does not apply to hire-purchase transactions. Hire-purchase accounting is governed more by convention than by a well-coded statement.
Some guideline is available in Accounting Standard on Fixed Assets Accounting, which provides that assets taken on hire-purchase, deviating from the legal ownership of the assets, will be put on the balance sheet of the hirer.
Thus, in case of hire-purchase transactions, India follows the international accounting standards - the asset is put on the balance sheet of the hirer, with a corresponding liability, and the hire instalments are broken into principal and interest, with the latter being taken as the hire-vendor's income and the hirer's expense.
The only notable question is the manner of allocation of the interest or finance charges over period. There are 3 methods usually in vogue:
The straightline method results into an equal, and hence, unfair distribution of finance charges over time, since the interest cannot be equal in the face of a declining sum invested.
Of the sum-of-digits approach and the IRR or capital recovery approach, the former is an over-simplified approach, belonging to the era when technology for exact determination of the IRR and splitting of rentals was not available. Today, it is something which can be done in a jiffy. Therefore, there is no rationale in sticking to the sum-of-digits approach.
The difference between these two approaches may be noted: under the sum-of-digits approach, the interest recognised declines linearly over time. Under the capital recovery approach, the interest declines in a curvilinear fashion - the decline is lesser in the beginning and precipitates over time. Hence, the sum-of-digits approach leads to an income inflation towards the beginning of the lease.
10. Accounting for non-performing lease and hire-purchase assets:
There is nothing in the Guidance Note on lease accounting for non-performing assets. The general accounting principles for sticky assets is contained in Accounting Standard 9 on Revenue Recognition, which is more or less on the lines of the International Accounting Standard on the issue.
The Standard provides that whereas, in general, incomes are to be recognised on the basis of accrual, in case of an uncertainty in the ultimate realisation of an income, the treatment shall be as follows:
This statement lays down the basic difference between a provision against and income, and non-recognition of an income which is very significant.
The accounting for non-performing assets is governed by the Prudential Norms of the RBI. The general regulation of the RBI on non-banking financial companies is discussed separately - click here.
click here for the text of the RBI's Prudential Directions.
A lease or hire-purchase asset will be considered as non-performing asset based on overdues for more than 12 months. That is, if dues under a lease or hire-purchase transaction remain unpaid, fully or partly, for more than 12 months, the transaction will be treated as a non-performing asset. The 12-month time frame is markedly longer than the general international standard of 3 months only. In fact, in India itself, the time frame for loans is 6 months - it is difficult to understand what prompted the RBI to allow 12 months in case of lease and hire-purchase transactions.
If a lease or hire-purchase transaction is a non-performing asset, there is 4-fold impact on the revenue/provisioning requirements:
11. Other useful links on lease accounting:
Institute of Chartered Accountants of India
International Accounting Standard Committee