Lease Accounting Services
Lease accounting is an essential accounting section as it differs depending on the user's end: a lessor and a lessee report and account lease in a different manner. A lessor is the owner of the said asset, and a lessee uses the leased asset by periodically paying to the lessor. The accounting and reporting of the lease in different ways have varying effects on the financial statements and ratios.
A lease is a legal agreement by which the owner of a specific asset or lessor allows the lessee or the second party to use the asset for a particular period in exchange for periodic payments to the lessor. These regular payments are known as lease rentals. It permits the lessee to use leased assets for a certain period of time, generally less than the asset's useful life. It can generally be used for leasing equipment for short terms. A finance lease is quite similar to buying an asset via external finance. The lessee has got the option to become a permanent owner of the asset at the end of the term of the lease.
Advantages of Leasing as per Lease Accounting
The main advantage of leasing as per lease accounting is mentioned below:
- A lessee can use the asset without purchasing it, which means full finance without any margin money.
- The requirements also provide flexibility in the fixation of the rent and the period of the lease.
- In the lessee’s balance sheet, the leased assets are not shown as an asset or liability of the company. Therefore the credit capacity of the lessee remains unaffected.
- By way of a lease, the lessee gets an opportunity to earn additional profit and also to improve earnings per share.
- As a business expenditure, the deduction of rent gets eligible for claiming tax benefits.
- Without making any significant investment, the lease rent can be paid out from the income generated by the assets' use.
- As per the Income Tax Act, 1961, the tax benefit of the depreciation can be claimed by the lessor.
- It is possible to take advantage of the full utilization of the asset as per the lease agreement. The ignorance chance is high, where the company purchases assets as its own.
- In the case of a closely held company, it also provides better wealth planning solutions.
- It also protects the lessee against any type of inflation.
- Strict provisions of the financial institutions for the purpose of acquiring assets can be avoided by way of a lease agreement.
Disadvantages of Leasing as per Lease Accounting
The disadvantages of leasing as per lease accounting are enumerated below:
- Leasing is not much beneficial for some of the new businesses, as earning by way of business come much after the investment.
- Due to the lease agreement, some of the incentives provided by the State and Central Government cannot be enjoyed due to the lease agreement.
- The assets, whose values are likely to appreciate in the future, must be purchased instead of leasing.
- In case of a variation clause in a lease agreement, the rental structure can be changed due to the change in the rate of interest, rate of depreciation, etc.
How is Lease Classified for the purpose of Lease Accounting?
The classification of leases that have been adopted in the Indian Accounting standard is based on the extent to which risks and rewards that are incidental to ownership lie with the lessor or the lessee. Due to the changing economic conditions, there are possibilities of risks that result from idle capacity or technological obsolescence and variations. Rewards are represented by the expectation of profitable operation on the asset's economic life and from appreciation's profit in value or realization of residual value.
A lessee must classify a lease as a finance lease for the purpose of lease accounting when any of the following criteria are met:
- The ownership of the underlying asset gets shifted to the lessee by the end of the term of the lease.
- The lessee has got the purchase option to buy the leased asset, and will undoubtedly use it.
- The lease term also covers a significant part of the underlying asset's remaining economic life. This is about 75% or more of the remaining economic growth of the underlying asset.
- The current value of the sum of all the lease payments and any lessee-guaranteed residual value matches or exceeds the fair value of the underlying asset.
- The asset is prioritized that it has no alternative use for the lessor after the lease term.
In the books of lessor:
- The total value of the investment plus the income receivable will be treated as receivables in the Balance sheet.
- Direct expenses can be directly debited from the Profit and Loss Account in the year of expenses incurred or can be deferred up to the period of the lease.
In the books of the lessee
- The initial direct cost shall be treated as an asset.
- The leased assets' fair value must be considered an asset and a liability in the finance lease.
- It is appropriate to show liability separately in the Balance sheet.
Disclosure in case of Finance Lease
- The assets that are acquired on the lease must be shown separately.
- For all the leased assets, the net carrying amount must be shown at the balance sheet.
- It must provide a reconciliation between the minimum lease payment at the balance sheet and also their present value.
- The total of minimum lease payment must be disclosed at the balance sheet and their present value for:
a) Not later than one year.
b) Later than one year but not later than five years.
c) Later than five years.
- The minimum sublease payment that is expected to receive in the future must be mentioned at the balance sheet with the date.
- The general description of the lessee that is major must be specified in leasing arrangements.
An operating lease is said to be an agreement wherein the lessor or owner permits the renter (lessee) to use the agreed asset for a particular period of time. Generally, the lease period is shorter than the economic life of the asset. Further, the lessor does not transfer ownership rights. The lessor also gives the right to the lessee for using the asset in return of regular payments for an agreed period of time.
According to AS-19, the following are the accounting treatment in the books of both the lessor and lessee:
In the books of lesser:
- The assets shall be treated as the fixed assets in the Balance Sheet of a lessor.
- The Rental Income shall be treated as an income in the Profit and Loss Account.
- The depreciation must be treated as expenses and should be debited from the Profit &Loss Account.
- An initial cost can be deferred to the asset's lease period, or it might be booked as expenses in the year in which it is incurred.
- As prescribed in AS-6, the depreciation will be charged.
In the books of the lessee:
The rental payment must be treated as expenses in the Profit and Loss Account of the lessee.
Disclosure in case of Operating Lease
- The future lease payment for the following period:
a) Not later than one year;
b) Later than one year but not later than five years;
c) Later than five years.
- Total Expected future lease payment.
- Lease payment recognized in the statement of Profit and Loss for the period.
- General Description of Lessee's significant leasing arrangements.
Why is it Important to Apply Substance To a Lease in a Lease Accounting?
A lease agreement is explained as a contract between two parties, the lessor and the lessee. The lessor is the asset's legal owner, whereas the lessee gets all the right to use the asset in return for the rental payments.
Before, the assets that were used but not owned were not mentioned in the statement of financial position, and hence any associated liability was also left out in the statement. This was known as off-balance sheet finance and was also used by the companies to keep their liabilities low, thus distorting other critical financial ratios. This form of accounting did not represent the transaction. In reality, a company often effectively owned these assets and owed a liability.
Under the current Accounting framework provided by IASB states that an asset as a resource that is controlled by an enterprise as a result of past events and from which future economic benefits are expected to flow to the entity. The liability is the present obligation of the organization that arises from the previous events, the settlement of which is likely to result in an outflow from the business resources that embody economic benefits. These substance-based definitions basically form the platform for IAS 17, leases.
Impact of Lease Accounting on the Financial Statements of Lessor
The financial statements of the lessor get impacted in lease accounting by the difference in both the leases in the following ways:
- The lease revenue is similar to the total cash flow in both cases.
- The income in the early years is higher in finance lease than that of the operating lease.
- Income in the later years is lower in finance lease than that of the operating lease.
- The operating cash flow in the finance lease is lower than an operating lease.
- The amount of taxes paid in the early years is higher in finance lease than an operating lease.
The accounting and reporting of a lease differ from both the perspective of a lessor and a lessee. It also further varies depending on the type of lease – finance or operating. Hence, the lease must be appropriately categorized and reported as it has numerous implications on financial statements and financial ratios.
Impact of Lease Accounting on Financial Ratio of the Lessee
As with the financial statements, the financial ratios also impact lease accounting by the different leases:
- The current ratio, asset turnover ratio, working capital, fixed asset turnover ratio, return on assets in initial years, and return on equity are lower in the finance lease.
- Return on assets in afterwards, return on equity in later years, debt to assets ratio and debt to equity ratio is higher in the finance lease.
Difference between IAS 17 and IFRS 16 in Lease Accounting
In lease accounting, the difference between IAS 17 and IFRS 16 is explained below in detail:
As per IAS 17, all the lease rentals must be charged to the statement of profit and loss account on a straight-line basis for an operating lease. It will provide a systematic basis, which is more appropriate if the payment to the lessor is not made on a straight-line basis.
According to IFRS 16, for an operating lease, all lease rentals must be charged to the statement of profit and loss as per the lease agreement unless the payments to the lessor are structured. The amount must be structured in such a way to increase in line with the expected general inflation to compensate for lessor’s expected inflationary cost that is associated with the lease. If the payments vary for a lessor because of any other factors other than general inflation, then the condition is not met.
How can Enterslice Assist You in Lease Accounting?
Enterslice understands the impact of the lease accounting standards on your company. We know this is not a one-time implementation issue; hence, we have developed the following service offerings to assist with compliance and a long-term business solution.
- General diagnostic discussion with management.
- Consultation and interpretive guidance.
- Assistance with tool identification and vendor evaluation.
- Assistance to management with identification of unknown or embedded leases.
- Assistance in identifying additional disclosures.
- Assistance in identifying additional reports and data needed.
- Analysis of potential impact on debt covenants.
- Analysis of potential impact on compensation agreements.
- Reviews the company’s filings for comparable companies in similar industries.