Definitions
Meaning of Lease
Lease is an agreement whereby Lessor conveys to the Lessee right to an asset for agreed period of time in return of a payment or series of payments.
Types of Lease
As per AS, Lease agreement can be classified under two separate heading as follows.
Operating Lease: Operating Lease agreement is the agreement which can’t be recognized as finance lease.
Finance Lease: Finance Lease is the agreement whereby all the risks and rewards incidental to ownership are transferred by Lessor to Lessee.
<!--[if !supportLists]-->v <!--[endif]-->If major part of life of the asset is covered by lease agreement then agreement can be classified as finance lease agreement (Meaning of major part is not explained in the provisions of AS but in practical questions more than 2/3rd can be considered as major part)
<!--[if !supportLists]-->v <!--[endif]-->If any option to purchase is specified in the lease agreement at the end of lease period then agreement can be classified as finance lease agreement.
<!--[if !supportLists]-->v <!--[endif]-->If any lessee is bound to purchase the leased asset at the end of lease period then agreement can be classified as finance lease agreement.
<!--[if !supportLists]-->v <!--[endif]-->If nature of asset is only useable for lessee without modification then agreement related to such asset should be classified as finance lease agreement.
<!--[if !supportLists]-->v <!--[endif]-->Present value of MLP should be equal to or higher than cost of Lessor (fair value) then agreement can be classified as finance lease agreement.
Imp Notes: At least 3 conditions should be satisfied out of 5 conditions as specified above to classify an agreement as finance lease agreement.
Ques 3.
As per AS – 19 any lease agreement can be claimed as finance lease agreement if the 3 conditions out of 5 conditions are satisfied. These conditions are discussed above.
In the given situation only two conditions can be analyzed. Total life of the asset is 12 yrs but lease agreement covers only 5 yrs which is not a major part of life. Further amount of rental is not equal to fair value of assets.
On the basis of available situations the lease agreement should be classified as operating lease agreement because features of agreement are not in the favour of finance lease agreement.
Ques 6.
W.N.1 Calculation of Present Value of Rental
Period Rental PVF (18%) P. Value
0 40000 1 40000
1 25000 0.847 21175
2 15000 0.718 10770
3 10000 0.609 6090
Total 78035
Comment: Present value of rental is not equal to fair value of the asset on the date of lease agreement. On the basis of such calculation agreement should be classified as operating lease agreement. Other conditions are not specified in the question so other conditions should be ignored.
Accounting for Operating Lease
- Books of Lessor
- Books of Lessee
Books of Lessor
As per AS, accounting in the books of Lessor under operating lease should be made with the help of following steps.
Step 1: First of all Lessor shall receive amount of rentals which are payable by lessee at the time of receipt of rental the following journal entry shall take place.
Bank A/c Dr.
To Lease Rental
Step 2: Amount of rentals should be recognized as normal income for lessor and to be taken to P&L A/c.
Lease Rental Dr.
To Profit & Loss A/c
Exception of Step 2: It may be possible that amount of Lease Rental is not equal over the lease period. In such case income from lease rental in the books of lessor can be recognized only by SLM. It means that equal income can be recognized over the lease period. ( Difference between actual collection and income should be recognized as advance income or receivable income.)
Receivable Income Dr. (B.F.)
Lease Rental Dr. (Actual)
To P&L A/c (SLM)
To Advance Income (B.F.)
Ex:
Period Lease Rental
1 25000
2 30000
3 5000
Pass journal entries in the books of lessor assuming operating lease.
Ans:
W.N. 1 Calculation of SLM rental
1 25000
2 30000 SLM = 60000 / 3 = 20000
3 5000
Journal Entry
1st Year
Bank A/c Dr. 25000
To Lease Rental 25000
Lease Rental Dr. 25000
To P&L A/c 20000
To Advance Income 5000
2nd Year
Bank A/c Dr. 30000
To Lease Rental 30000
Lease Rental Dr. 25000
To P&L A/c 15000
To Advance Income 10000
3rd Year
Bank A/c Dr. 5000
To Lease Rental 5000
Lease Rental Dr. 5000
Advance Income Dr. 15000
To P&L A/c 20000
Imp Note: It may be possible that technique SLM is not accurate for the presentation of financial statements. In such a case lease rental can be divided between different periods on the basis of systematic allocation.
Ex. Lease Rental = 5 yrs
Rentals = Rs 10 Lakhs p.a.
Cost of Lessor on the date of Lease agreement = 100 Lakhs
Life of Assets = 10 Yrs
Assumed Int. rate on Investment = 10%
Prepare a statement on the basis of systematic allocation.
Ans: Statement showing Systematic allocation
Period
|
Investment use
By Lessee
|
Interest
(Assumed)
|
Rental
(
|
1
|
100 Lakhs
|
10 Lakhs
|
10 / 40 x 50 = 12.50 Lakhs
|
2
|
90 Lakhs
|
9 Lakhs
|
9 / 40 x 50 = 11.25 Lakhs
|
3
|
80 Lakhs
|
8 Lakhs
|
8 / 40 x 50 = 10.00 Lakhs
|
4
|
70 Lakhs
|
7 Lakhs
|
7 / 40 x 50 = 8.75 Lakhs
|
5
|
60 Lakhs
|
6 Lakhs
|
6 / 40 x 50 = 7.50 Lakhs
|
50 Lakhs
|
Books of Lessee
<!--[if !supportLists]-->(a) <!--[endif]-->First of all Lessee shall record the payments of rental according to Lease agreement.
Lease Rental a/c Dr.
To Bank
<!--[if !supportLists]-->(b) <!--[endif]-->Amount of Lease rental should be written off in P&L a/c as normal expenses.
To Lease Rental
Exception: It may be possible that Lease rentals over the lease period are not same. In such case amount of expense should be written off on SLM basis. (Difference between actual payments & SLM amount should be recognized as prepaid expense or outstanding expense.)
Ex. Lease Period Amount
1 10,000
2 2,000
3 8,000
4 10,000
Ans
W.N.1 Calculation of SLM Exp
10,000 + 2,000 + 8,000 + 10,0000 = 30,000
SLM = 30,000 / 4 = 7,500
Entries
1st year Lease Rental A/c Dr. 10,000
To Bank 10,000
Prepaid
Exp Dr.
2,500
To Lease Rental A/c 10,000
2nd year Lease Rental A/c Dr. 2,000
To Bank 2,000
To Lease Rental 2,000
To Prepaid Exp. 2,500
To O/s Exp. 3,000
3rd year Lease Rental Dr. 8,000
To Bank 8,000
O/S Exp. Dr. 500
To Lease Rental 8,000
4th year Lease Rental Dr. 10,000
To Bank 10,000
O/S Exp. Dr. 2,500
To Lease Rental 10,000
Accounting for Operating Lease
Meaning of M.L.P. (Minimum Lease Payment)
MLP are the amounts which are payable by lessee to the lessor over the lease period. Amount of MLP shall include only two amounts.
<!--[if !supportLists]-->(a) <!--[endif]-->Lease Rentals
<!--[if !supportLists]-->(b) <!--[endif]-->GRV (Guaranteed Residual Value)
GRV is the minimum price or amount which is require to be paid by lessee at the end of lease period to lessor in addition to lease rentals. GRV can be different from residual value which is actually available at the end of lease period.
The following points may be considerable in practical questions at the time of difference between GRV & RV:-
If RV is lower than GRV: If residual value is lower than GRV then difference will be paid by lessee assuming extra use of asset than estimated use in such case the lessee has to pay such difference in cash and also to return the assets if he is not interested to purchase the asset.
In case lessee is interested to purchase the assets the end of lease period then lessee shall pay amount of GRV to the Lessor for the purchase of assets.
If RV is higher than GRV: If residual value is higher than GRV, difference should be recognized UGRV. Benefit of UGRV will be given to lessor only because he is the actual owner of the asset.
In case of UGRV, no additional cash will be paid by lessee at the time of return of asset. But Lessor shall charge total residual value at the time of sale of asset. (UGRV = RV – GRV)
Meaning of Gross Investment
Gross Investment is the tool of inflow which is expected to be included or received from the point of view of lessor. Total inflows of the lessor shall include amount of lease rental + amount of GRV + amount of UGRV.
Meaning of Net Investment
Net Investment is the amount of outflow which is invested by lessor on the date of lease agreement. Net Investment can also be recognized equal to face value of the assets on the date of lease agreement.
Meaning of Finance Income
Difference between inflow and outflow should be recognized as Finance Income from the point of view of lessor because it is assumed by Finance Lease that assumed ownership is transfer by lessor to lessee on the date of lease agreement.
Meaning of I.R.R. (Implicit or Internal Rate of Return)
Internal rate of return is the rate at which gross investment & net investment will be equal. It can also be said that IRR is the rate at which inflow & outflow of the lessor will be equal.
Calculation of IRR
Step – 1: Assume any two rates
Step – 2: Calculate PV factors at the assumed rates
Step – 3: Calculate present values of inflows by the PV factors of assumed rate.
Step – 4: Calculate difference between inflow & outflow by taking present value at the assumed rate.
Step – 5: After calculating difference apply the following equation:
IRR = Lower Rate + Lower rate Diff(NPV) X Diff in Rates
to="342pt,-.25pt"/><!--[if !vml]-->
<!--[endif]--> Lower Rate Diff – Higher rate diff
Ex. Lease Period = 4 years
Lease Rental = 5 Lakhs p.a
G.R.V. = 1,00,000
R.V. = 3,00,000
F.V. = 16,00,000
Calculate IRR.
Ans.
Calculation of NPV
Period
|
Inflow
|
PVF 10%
|
PVF 15%
|
PV 10%
|
PV 15%
|
1
|
5,00,000
|
0.909
|
0.870
|
4,54,500
|
4,35,000
|
2
|
5,00,000
|
0.826
|
0.756
|
4,13,000
|
3,78,000
|
3
|
5,00,000
|
0.751
|
0.658
|
3,75,500
|
3,29,000
|
4
|
5,00,000
|
0.683
|
3,41,500
|
2,86,000
| |
4
|
3,00,000
|
0.683
|
0.572
|
2,04,900
|
1,71,600
|
Total
|
17,89,400
|
15,99,600
| |||
Less: P.V. of Outflow
|
(16,00,000)
|
(16,00,000)
| |||
Difference
|
1,89,400
|
(400)
| |||
IRR = 10% + 189400 / [189400 – (-400)] X 5
= 14.98%
Books of Lessee
As per AS Accounting for Lease in the books of Lessee should be made by considering the following steps:-
Step – 1: First of all Lessee shall recognized purchase of asset as well as liability to lessor.
Assets on
Lease A/c Dr
.
To Lessor A/c
Step – 2: Lessee will recognize the assets & liabilities as recorded above as lower amount out of following:
PV of MLP or Fair value
Step – 3: After recognition of assets & liabilities, lease rentals as per lease agreement will be paid by the Lessee. The following journal entry should be recorded.
Lease Rental A/c Dr.
To Bank
Step – 4: Amount of lease rental should be divided between payment to Lessor and Interest expenses (finance charge)
Interest Exp = Balance O/S in Lessor account x IRR
Lessor Payment = Rental – Interest
Interest Exp. A/c Dr.
Lessor A/c Dr.
To Lease Rental
To Interest
run:� a9>��b���0 Lakh 6.30 Lakh
Working Capital 110 Lakh 9.90 Lakh
650 Lakh
Treatment: -
<!--[if !supportLists]-->(a) <!--[endif]-->Interest of Rs. 10.80 Lakh and 31.50 Lakh should be capitalized in the cost of building and plant respectively. Because these assets are ready for use at the end of the year.
<!--[if !supportLists]-->(b) <!--[endif]-->Interest of Rs. 6.30 Lakh should be also be capitalized in the name of Capital WIP because advance payment for installation of plant has been made and it can be assumed that administrative activities which are required to complete have been in progress.
<!--[if !supportLists]-->(c) <!--[endif]-->Working capital is not qualifying asset so interest related to working capital should be transferred to P&L a/c.
Note: Wherever in any ques there is difference in the amount of expenditure as well as period of progress then gross borrowing cost should not be allocated in the ratio of expenditure but the following steps should be applied.
Step1:
First of all average capitalization rate should be calculated on average basis.
Capitalization rate = Total Borrowing cost X 100
<!--[endif]--> Total used amount during the period
Step 2:
After calculation of capitalization rate, such rate should be applied on the expenditure of qualifying assets directly with reference to period of construction or progress.
Ques 14
W.N.1 Calculation of Capitalization rate
Total used amount during the period
18% Bank Loan = 1000 x 12/12 = 1000
14% Debenture = 2000 x 6/12 = 1000
16% Term Loan = 3000 x 9/12 = 2250
<!--[endif]--> 4250
<!--[endif]--> |
filled="f">
<!--[endif]--> Capitalization Rate = 180 + 140 +360 X 100 |
4250
Statement showing allocation of Gross Borrowing Cost
Factory Shed 2500 x 16% x 12/12 = 400.00
Plant I 1500 x 16% x 9/12 = 180.00
Plant II 1000 x 16% x 7/12 = 93.33
<!--[endif]-->Total Capitalized Cost 673.33 |
Comment:
Total Borrowing cost is of Rs. 680 but cost can be capitalized to the extent of Rs. 673.33 as per above statement. Difference between total cost and capitalized amount should be transferred to P&L a/c because expenditure is lower than total borrowings.
Disclosures: (Notes to Account)
<!--[if !supportLists]-->1. <!--[endif]-->Accounting policy should be disclosed separately.
<!--[if !supportLists]-->2. <!--[endif]-->Amount of borrowing cost which is capitalized during the period should be disclosed separately.
Difference between AS – 16, IAS – 23 and US
Difference between the three Statement is not important because such difference is not related to accounting of borrowing cost but it is related to disclosure only.
<!--[if !supportLists]-->1. <!--[endif]-->As per IAS – 23, amount of interest expense which is capitalized or not capitalized during the period should be disclosed separately.
<!--[if !supportLists]-->2. <!--[endif]-->As per US GAAP – 34, amount of capitalization is not required but capitalization rate should be disclosed separately.
<!--[if !supportLists]-->3. <!--[endif]-->As per AS – 16, if any interest cost is not capitalized during the period then no disclosure will be required. It means that disclosure requirements are applicable only if capitalization of borrowing cost has been made during the period.
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