i ans CHAPTER : 14 LEASE TRANSACTION S-THEORY Q. 1. What is Lease ? Ans. A lease is usually a written agreement between an owner Of proper (land, building, equipment, vehicle, etc.) and a person OF business that will use the property for a stated period of time at a specified series of payments. The owner of the property is known as the lessor and the person using the property is the lessee. Some leases are for short periods of time and there is no intention of transferring ownership of the asset in exchange for the rent payments. Two examples of this type of lease are 1) the lease for a one-bedroom apartment covering a 12-month period and rent payments of $1,100 per month, and 2) the lease of anew automobile for 24 months with payments of $300 per month. Other leases may be for longer periods and ownership of the asset will transfer to the lessee for a small additional payment. An example is a noncancellable lease requiring 60 monthly payments of $600 per month for a forklift truck. At the end of the lease period (after the 60th payment) the lessee may take ownership of the forklift truck for an additional payment of $500. Since leases are contracts requiring a series of payments, there is a question of how the lease and the related payments should be accounted for by the lessee and the lessor. As of September 2015, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) were close to issuing a common financial accounting reporting standard that will replace the present US. accounting rules. e Q. 2. What is lease Accounting ? Ans. A lease is an arrangement under which a lessor agress to allow a lessee to control the use of identified property, plant, and equipment, for a stated period of time in exchange for one or more payments, There are several types of lease designations which differ if an entity is the lessee or the lessor, The rice fora lesse are that a lease can be designated as either a finance lease or an operating lease x A Lease is an agreement under which lessee (the A kes - erson/entity, who ‘! possession of the property) get the to.use the wal onan period of time in lieu of the rent as agreed| both Lessor (owner) Lessot has an ownership right of assets, but still lessee has, paces Be that asset. “ ste pied ve * Every lease contract should cover the following terms “ * Period of lease, ; Se EX & . eeLease Transactions-Theory 143 « Timing of the payment to be made along with the amount of rent. « About maintenance expenses, agreement. The Accounting Standard 19, issued by the Council of the Institute of Chartered Accountants of India, covers the disclosure of appropriate accounting policies in the financial statements. taxes, insurance, provision for renewal of lease Standards 19 are mandatory in nature and applicable to all lease agreements except some given below ” * Lands to be used under the lease agreement. * For use of natural resources like oil, gas, timber, metal, etc. * Video recording, films, motion picture, patents, and copyrights. Important Terms in Leasing—Following important terms are commonly used in lease accounting ” Lessee—” Lessee is a person who possess the right to use the asset in lieu of agreed rent for a certain period of time (as per the lease agreement). Lessor— “ Lessor is the owner who gives right to the lessee to use his asset/ property in lieu of rent for a certain period of time. Lease Term— “ Usually, lease agreement is contracted for a fixed and non- cancellable period called as lease term. It is also known as ‘Lease Period.’ Lease term may be further extended as agreed with or without further amendment/s. Fair Value— ” Fair value is an amount on which an asset can be exchanged or it may be the value of liability settled. Useful Life—“ It can be A period over which an asset could be used by the lessee. Expected number of units that can be produced by that asset. Inception of Lease— “ It is the date on which principal provision of the lease are committed to. i Residual Value— “ An estimated fair value of an asset at the end of the lease term is called as residual value. eee iinimum Lease Payment—“ Total payment | dire the lease terms dine taxes, insurance, maintenance charges, contingent rent, etc. Contingent Rent—" It is based on a factor other than passage of time, lease ayments i.e. percentage of sale, etc. : ecanmiueed racial Value— “ An expected fair value at the end of the lease period is called as Unguaranteed Residual Value. 5 ‘ Popularity of Leasing—One of the main reasons behind the popularity of leasing is its simplicity to both the parties i.e. lessor as well as lessee. It is beneficial in terms of its documentation and also provides tax advantage. Selection and Purchase of asset come under the purely of leasing company, and use and rent Payment of the assets are the part of lessee. s Since lessor remains owner of the. ) he can claim for the depreciation in his books. Interestingly, he cz benefit against the depreciation.144 AMAR ::B. Com. (Financial Accounting) | Year (Sem. 1) fh rent in his books as expen Similarly, lessee pays the rent and records suc! esi the ose of tax benefit. Eee J : Taafanisies of Leasing—Main advantage of leasing is given hereunder * Lessee can use the asset without actually purchasing it, means full financy without any margin money. ; It provides flexibility in fixation of the rent and the lease period as per thy Juirements. ite Balance sheet of a lessee, leased assets are not shown as asset o, liability of the company, hence the credit capacity of the lessee Temaing un-affected. Fig . Leasing provides an opportunity to lessee to earn additional profit and tp improve earnings per share. : ; : Deduction ofa rent is eligible to claim tax benefit (as business, expenditure), Without heavy investment, lease rent. can be paid out from the income generated by the use of the assets. 2 ‘Tax benefit of the depreciation may be claimed by lessor according to the Income Tax Act. aD Taking advantage of the full utilization of the asset is possible under a lease agreement; chances of ignorance are high, where company purchases asset as its own. In case of a closely held ¢ it ides better wealth planni solutions. : = It provides protection to lessee against the inflation. Strict provisions of the financial institutions for acquiring an asset can be avoided through a leaseagreement. See Disadvantages of Leasing Some of the disadvantages of leasing are” cannot be enjoyed due to lease, * The assets, whose values are likely to appreciate, should be purchased instead of leasing, * In case of variation changed due to ch: ee 0 iged due to change rate of iation, etc. Q. 3. What are Lease Classification 2 imeret rte of depreciation Ans. Lease classifications inelude Operating leases and capital leases. A leas? ‘Ss Bt f is a type of transaction undertake Ina direct purchase, a company company to have the right to use an asset: ‘ hase the asset off of another pa" Ina lease, however, he co pay the hy aca money, not unlike rent in e fo the ability touse tne eee 4 use the asset is known as the lessee. TLease Transactions-Theory 145 There are two types of lease classifications: the o finance lease. perating lease and the capital or fini . An Operating Lease—In an Operating lease, the lessee receives the right to use the asset but does not record the asset or the lease payment liability on its balance sheet. Thus, the Operating lease is considered to be “off-balance sheet financing”. Instead, the lessee will record lease payments as rental expense in its income statement, either under cost of goods sold or under SG&A. A Capital or Finance Lease—In a capital lease, the lessee receives the right to use the asset and substantially receives all the benefits and risks of owning that asset. This transfer of risk and benefits can occur when certain criteria are met. A capital lease can be assumed ff: The lease duration is 75% or more of asset's useful life; The net present value (NPV) of lease payments is 90% or more of the asset's fair value; There is a direct term or clause in the lease stating transfer of title; or, There isa term in the lease that allows the lessee, at the end of the lease, to purchase the asset at a discounted price (also knownas a bargain purchase option, or BPO). ‘As opposed to the operating lease, a lessee in a capital lease will record the asset and the corresponding lease liability in its balance sheet. The asset will be classified as plant, property and equipment while the lease liability is classified as a form of debt. . The lessee will also depreciate the asset over time, simply to the salvage value of the asset. If the lessee and lessor have agreed on a guaranteed residual value, which is a contractual agreement to return the asset at a certain market value, then the lessee will depreciate the asset over time to this residual value. Any non-cash financing for this lease is disclosed in the footnotes of the containing financial statement. Significance of the Lease Classifications — Because ‘of the nature of each lease classification, there can be an impact on profit and debt capacity. Since operating leases are off-balance sheet, the company’s capital structure does not change due to the operating lease. In contrast, a capital lease may make a company more debt- heavy, thereby impacting its debt capacity. Q. 4. Briefly, explain the accounting treatment of different types of lease ? Ans. Classification of Lease— According to AS-19, following are the two categories of Leasing “ * Operating lease * Finance Lease rating Lease—Operating lease is an agreement wherein the lessor (owner) nak aaa oe use the agreed asset for a particular period. Dally the lease period is shorter than the economic life of the asset. Further, lessor ownershi a actually tr p rights. The Lessor gives the right to the lessee 0 iy stint regular payments for an agreed period of time.] 1 Year (Sem. 1 } 146 AMAR: B, Com. (Financial Accounting) ( 1) ‘Accounting Treatment—As per AS-19, following are the accounting trea in the books of lessor and lessee ” * Inthe books of Lessor “ ae eer ixed assets in the Balan a lessor, Assets should be treated as the fix Se axoutriibclLens Rental income should be treated as an : Depreciation should be treated as expenses and should be debited from, the Profit & Loss account. © An initial cost can be deferred to the lease period of the asset or may be booked as expenses in the year, in which actually incurred. Depreciation will be charged as per AS-6. In the books of Lessee “ * Lessee should treat a rental payment as expenses in the profit and loss account, _ Finance Lease—In case where leas his capital outlays plus a reasonable r period is called financing lease. Fis lessor is not responsible for any exp Accounting Treatment— * In the books of Lessor “ . * Total value of the investment p as receivables in the Balance * Direct expenses may be direc in the year of expenses inc * Inthe books of Lessee ” * Initial direct cost will be * Fair value of the leased assets sh in the finance lease. It is an appropriate to show