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Query No. 6 Subject: Computation of lease term and accounting for scheduled rent increases in case of an operating lease.1 A. Facts of the Case 1. A company is in transport industry and provides radio taxi services across India. The company (hereinafter referred to as ‘the lessee’) has taken on 1st September, 2007, a premises on lease. The term of the lease is 5 years and it is renewable at the end of the lease term. The querist has provided the following clauses of the agreement (hereinafter referred to as the ‘first lease agreement’): “That the lease shall be for a period of 5 years, commencing from 1st September, 2007. On expiry of the lease period of 5 years, the lease can be renewed. After 12 months, 5% enhancement will be done every year.” “That notwithstanding that is stated above, this agreement is terminable by 3 months notice in writing by either side.” According to the querist, there is no non-cancellable period in the agreement as there is no lock-in-period. 2. On 1st August, 2007, the company has taken another premises on lease. The querist has provided the following clauses of the agreement (hereinafter referred to as the ‘second lease agreement’):

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“In consideration of the lease rental hereinafter reserved and all the covenants and conditions hereinafter contained to be observed and performed on the part of the lessee, the lessor does hereby agree to grant, demise by way of lease the demised premises to the lessee for a period of five years from 1st August, 2007 to 31st July, 2012 with the sole and absolute option of lessee to extend the lease for a period of four years on the same terms and conditions, except rent, by execution of fresh lease agreement for such extended period of four years. After expiry of subsequent four years, i.e., on 31st July, 2016, if extension is required a fresh lease deed shall be executed in writing and registered on mutually agreed rent, terms and conditions”. (Emphasis supplied by the querist.) “That the lease deed shall commence and come into operation with effect from 1st August, 2007.” “The rent shall be as follows: A. For the first three years of period commencing from 1st August, 2007 to 31st July, 2010, the rent shall be Rs. 5,15,000 per month (Rupees five lakh fifteen thousand only). B. For the second three years commencing from 1st August, 2010 to 31st July, 2013, the rent shall be Rs. 6,18,000 per month (Rupees six lakh eighteen thousand only). C. For the third three years, final period commencing from 1st August, 2013 to 31st July, 2016, the rent shall be Rs. 7,41,600 per month (Rupees seven lakh fourty one thousand six hundred only). However, a fresh deed will be executed and registered after the expiry of 5 years period.” “The lessee shall be entitled to terminate the lease by giving three months advance notice to the lessor and upon expiry of such notice period, the lessee shall hand over physical vacant possession of the demised premises to the lessor. However, in case the lessee wants to vacate the demised premises before the expiry of four years from the date of signing of this lease deed, the lessee can do so by giving four months advance notice to the lessor. During the notice period rent will be paid by the lessee.” As per the querist, there is no non-cancellable period in the agreement as there is no lock-in-period. The querist has further clarified that the lessor, under the agreement, does not have a right to ask the company to vacate the premises. 3. The querist has stated that there may be various kinds of lease agreements entered into by the company: (i) Lease agreement with no ‘non-cancellable period’. (ii) Lease agreement with non-cancellable period together with any further periods for which the lessee has the option to continue the lease (emphasis supplied by the querist). (iii) Lease agreement with cancellable period together with any further periods for which the lessee has the option to continue the lease.

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4. The auditors of the company have advised the company to consider all the periods, whether cancellable or non-cancellable lease term and equalise the rent over the lease term as per paragraph 23 of Accounting Standard (AS) 19, ‘Leases’. 5. In support of the company’s view, the querist has quoted the definition of ‘lease term’ as given in AS 19: “The lease term is the non-cancellable period for which the lessee has agreed to take on lease the asset together with any further periods for which the lessee has the option to continue the lease of the asset, with or without further payment, which option at the inception of the lease it is reasonably certain that the lessee will exercise.” The company believes that to qualify under the above definition, there has to be a ‘non-cancellable lease term together with any further periods for which the lessee has the option to continue the lease’. Therefore, in the view of the querist, the definition of ‘lease term’ should not apply to lease agreements of the type mentioned in paragraph 3(i) and (iii) above but will apply to lease agreements of the type mentioned in paragraph 3(ii) only. B. Query 6. The querist has sought the opinion of the Expert Advisory Committee on the following issues: (i) What should be the lease term in the case of second lease agreement? (ii) Whether there is a need to equalise rent over the lease term as per AS 19, if the option to terminate the agreement lies with (a) any of the parties (in case of the first lease agreement). (b) only with lessee (in case of the second lease agreement). (iii) Whether there is a need to equalise rent over the lease term as there is no lock-in-period (in case of lease agreements of the type mentioned in paragraph 3(i) and (iii) above) as per the definition of ‘lease term’ given in AS 19. C. Points considered by the Committee 7. The Committee notes that the basic issues raised in the query relate to determination of lease term and whether there is a need to equalise rent over the lease term. The Committee has, therefore, answered only these issues and has not gone into the specific cases under the two lease agreements cited by the querist in the absence of the relevant information with respect to both the agreements. The Committee presumes from the Facts of the Case that the lease under both the cases is an operating lease. 8. The Committee notes the following definitions from AS 19: “The lease term is the non-cancellable period for which the lessee has agreed to take on lease the asset together with any further periods for which the lessee has the option to continue the lease of the asset, with or without further payment, which option at the inception of the lease it is

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reasonably certain that the lessee will exercise.” “A non-cancellable lease is a lease that is cancellable only: (a) upon the occurrence of some remote contingency; or (b) with the permission of the lessor; or (c) if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or (d) upon payment by the lessee of an additional amount such that, at inception, continuation of the lease is reasonably certain.” 9. As far as the determination of lease term is concerned, the Committee is of the view that the lease term is the non-cancellable period for which the lease has been contracted plus further period(s) for which the lessee has the option to continue the lease provided such option at the inception of the lease it is reasonably certain that the lessee will exercise. If any of the terms contained in the lease agreement with respect to cancellation thereof, are covered by the definition of ‘non-cancellable lease’, the agreement will be treated as non-cancellable. If there are no terms in the lease agreement with respect to cancellation thereof, in the view of the Committee, it would also be treated as non-cancellable lease. Existence of a clause permitting termination of a lease agreement upon notice does not by itself amount to a cancellable lease. Moreover, existence of a clause of notice period in the lease agreement implies that as a minimum, the lease is non-cancellable for the duration of the notice period. With respect to the reasonable certainty of continuation of the lease term, the Committee is of the view that when a lease agreement is entered into for a certain initial period, that initial period can be construed as the period for which the lease of the asset is reasonably certain to continue at the inception of the lease. For any extension of the initial lease term to be treated as the ‘lease term’ in accordance with the definition reproduced in paragraph 8 above, the Committee is of the view that the reasonable certainty of renewal of the lease agreement at the inception of the lease should be considered. The same should be determined on the basis of the facts and circumstances of the case considering various factors, e.g., the expectation that the rentals during the period of renewal are expected to be considerably lower than the fair market value of the rentals at the date the option by the lessee becomes exercisable, the lessee has made substantial expenditure on leasehold improvements which have useful life much in excess of the initial lease period, importance of the lease to the business, or the fact that the lessee has entered into business commitments, the fulfillment of which would require renewing the lease of the premises beyond the initial lease term, uniqueness of purpose or location of the property, the availability of a comparable replacement property, ability or willingness of the lessee to bear the cost associated with relocation or replacement of the leased property at market rental rates, any past practice in this regard in comparable circumstances, etc. 10. With respect to equalisation of the rent over the lease term, the Committee notes the following paragraph of AS 19: “23. Lease payments under an operating lease should be recognised as an 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.” 11. From the above paragraph, the Committee is of the view that the lease rentals payable over the lease term should be recognised on a straight-line basis unless there is another systematic basis which is representative of the time pattern of the benefit derived by the lessee from that asset. The Committee is of the view that the Standard does not recognise increases in the lease rentals on a scheduled basis as a factor representing the time pattern

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of the user’s benefit. Accordingly, the lease payments, including the scheduled rent increases in the lease rentals, should ordinarily be recognised on a straight-line basis over the lease term as determined in accordance with paragraph 9 above. D. Opinion 12. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 6 above: (i) In view of non-availability of the relevant facts for determining whether the lease would be extended beyond the initial lease term, the specific issue with respect to lease term in the case of the second lease agreement is not being answered. As a matter of general principle, the lease term is the non-cancellable period for which the lease has been contracted plus further period(s) for which the lessee has the option to continue the lease provided such option at the inception of the lease it is reasonably certain that the lessee will exercise. For determination of the lease term, please refer to the discussion in paragraph 9 above. (ii) Irrespective of whether the option to terminate the lease agreement lies with the lessee or with both, the lessor and the lessee, the lease rentals should be equalised over the lease term unless another systematic basis is more representative of the time pattern of the user's benefit, as discussed in paragraph 11 above. (iii) Since there is no concept of ‘lock-in-period’ in AS 19, the question of considering the same while determining the need to equalise rent over the lease term does not arise. As discussed in paragraph 11 above, the lease rent is required to be equalised over the lease term determined in accordance with paragraph 9 above.

1Opinion

finalised by the Committee on 5.3.2009

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