Indian Accounting Standard 19 on Lease Accounting
By Vinod Kothari
The Institute of Chartered Accountants of India (ICAI) has issued accounting standard no. 19 (AS 19) on accounting for leases. ICAI apparently rode roughshod on the pleas of the leasing industry which vehemently tried to make a case for either deferring or substantially diluting the proposed accounting standard. However, the ICAI has finalised the standard, and made it mandatory for all assets leased during the accounting period commencing on or after 1st April 2001. Accounting periods of leasing companies, as required by the RBI regulations, would anyway harmoniously commence on 1st April 2001: result is that the new accounting standard is applicable for all lessors and all lessees effective 1st April 2001.
Scope of applicability
Some people harbor doubts as to whether the accounting standard is applicable only on leasing companies, or only on companies and not to banks, etc. These views are misplaced. Being an accounting pronouncement, the standard is applicable on all lease transactions irrespective of the entity entering into the same. Hence, the accounting standard is applicable to lessors and lessees, whether they are companies, firms, banks or any one else.
Standard applies to hire purchase as well:
One of the important features of the standard is that it applies to hire purchase transactions as well. There is no problem as far as capitalisation of hire purchase deals is concerned, as they are capitalised anyway on the books of the hirer. But there will be important implications on income recognition by hirers: the standard requires that income should be recognised on a pattern which leads to consistent income based on a yield on outstanding investment in the transaction.
Traditional hire purchase financiers in the country have been following the straightline income recognition method under which income is recognised equally, and not on declining balances, over term. This method will have to be discontinued.
What will be the impact of the accounting standard:
Before the standard was issued, it was widely being feared that the Standard will lead to rejection of finance leases for income-tax purposes as well. Though time and again, this author tried to allay these fears, the industry was unnerved. So much so that some of the larger finance companies made a representation to the ICAI, and one of them even went to the Court to stall the accounting standard.
However, it seems the CBDT has already clarified that the accounting standard, by itself, will not do any such damage. A report in Economic Times of 10th Feb talks of a circular issued on 9th Feb. Independent enquiries with the CBDT sources also confirms that there has indeed been such a circular.
Dichotomy between tax and accounting principles is there is many countries. All our neibhbours: Pakistan, Sri Lanka and Bangladesh, adopt international accounting standards for accounting purposes but allow the lessor to claim depreciation for tax purposes. Many other countries world-over also do the same thing.
Hence, what the ICAI has now done was only overdue.
So what impact is the accounting standard going to have? Off-balance sheet treatment of leases is over, if the lease is a financial lease. Are leases in India financial leases? The answer is obviously yes, for something like 95% of lease contracts in the country. However, in global leasing markets, practitioners have tried successfully dodging the accounting definition of a "financial lease" to carve out leases which are overwhelmingly financial in character, and yet do not fall under the definition of "financial lease". All that is employed to wriggle out of the definition is a doze of financial sophistry. Luckily, we do not have a dearth of financial structuring skills in the country, too.
This forced the International Accounting standards Committee (IASC) to go for a revision of the IAS 17, based on recommendations of an Australian scholar named Mr McGregor. These revised norms have already become applicable, and the revised norms do not make distinction between financial and operating leases from lessee's disclosure point of view, requiring lessees to disclose non-cancelable lease rentals even in case of operating leases as well.
Basis for distinguishing operating and financial leases:
Though there are 4 bases for distinguishing between financial and operating leases, in practice, in global leasing practice, the most relevant of these tests is the "present value test" or "full payout test".
Briefly speaking, what the present value test provides is that if the present value of minimum lease payments from the lessee's point of view is 90% or more of the fair value of the asset, the lease should be recognised as financial lease. The minimum lease payments from the lessee's point of view include any residual value guaranteed by him or by some one on his behalf.
In other words, if the lessor depends to the extent of more than 10% on a residual value which is not guaranteed by the lessee, the lease becomes a financial lease for the lessee. It is interesting to understand that as per the accounting standard, it is not uncommon to come across situations where a lease is a financial lease for the lessor, but an operating lease for the lessee.
In order to look at such structuring options, there are 3 elements which are critical: (a) the discounting rate of lease rentals from lessee's point of view; (b) the residual value of the asset and the portion which is guaranteed by the lessee or some other person; and (c) the unguaranteed value of the asset.
The discounting rate from the lessee's viewpoint need not be the IRR of the lessor, as in theory and in practice, there is no IRR for the lessee and the lessee is not supposed to be concerned with the lessor's IRR. Technically, as the lessor's IRR is inclusive of even the unguaranteed residual value, the lessor's IRR cannot be the same as the discounting rate for the lessee. If there are significant differences between the discounting rate from lessee's point of view and the IRR from the lessor's viewpoint, it is possible to design structures where the lease will be an operating lease for the lessee, though it might be a financial lease for the lessor.
The second variable is the guaranteed residual value. As per the standard, the residual value is to be included in the minimum lease payments from lessee's point of view, if it is guaranteed by the lessee or some other party on the lessee's behalf. In most developed leasing markets, accounting standards have bred residual guarantee companies who find it a good business to guarantee residual values. These values, guaranteed by third parties, will not be taken as a part of the lessee's minimum lease payments, thus qualifying the lease to be an operating lease for the lessee. At the same time, the lease will continue to give the needed protection for the lessor.
The third alternative is unguaranteed residual value. In some of the developed leasing markets, a practice called synthetic lease has come up which uses a special purpose vehicle as a leasing intermediary, whose debts are normally guaranteed by the lessee, thereby effectively meaning the rentals are guaranteed by the lessee, and yet it provides an operating lease to the lessee. There are some jurisdictions where parties go beyond the operating lease characterisation and even treat such a lease as a capital lease for tax purposes, thereby giving the best of both the worlds to the lessee: capital allowances as well as an off-balance sheet advantage.
Operating hire purchase: a new possibility:
If the current basis under income-tax laws of distinguishing between lease and hire purchase transactions remains, it is quite likely that the accounting standards might give rise to a new concept of "operating hire purchase". As per current income-tax law, capital allowances are granted to the user or hirer of the asset in case of hire purchase transactions.
Hire purchase transactions as defined in the Hire-purchase Act are those where the hirer has an option to buy. Unfortunately the hire purchase law does not qualify the option to buy as "option to buy at bargain values". So technically, any transaction which provides an option to buy to the user will be regarded as hire purchase transactions.
However, a hire purchase transaction for accounting standards will be treated as a finance lease only if it allows the hirer an option to buy at a bargain price. This only means that if one structures a hire purchase deal with an option to buy at significantly high option price, the hire purchase deal, though hire purchase for common law purposes, and therefore, for income tax and sales-tax purposes, will still not be a finance lease for accounting purposes. Does that not offer unique possibilities?
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