ACCOUNTING FOR LEASES (AS 19)

Lease is an agreement between owner of an asset (lessor) to grant the right of use of it to

another party, called the lessee for specified period, in consideration of specified periodic

payments, called the lease rents. The leasing may in effect be same as hire purchase

because the ownership of the asset can be transferred to the lessee for a small sum at the

termination of lease agreement. Prior to issuance of the Accounting Standard (AS) 19,

Leases, by the Institute of Chartered Accountants of India, all leases were treated as a mode

of off-balance sheet finance. This allowed enterprises not to recognise assets taken on lease

in their balance sheets and thus to understate their net assets and capital employed and

consequently to overstate their return on investment (ROI). The Accounting Standard (AS) 19,

Leases, has reduced the scope of this kind of window dressing by requiring enterprises to

recognise assets taken on certain types of leases, called finance leases. The finance leases

are those, in which risks and rewards of ownership are substantially transferred from the

lessor to lessee.

The policy of recognition of assets taken on finance lease is an example of principle of ‘substance

over form’ described in paragraph 17 of Accounting Standard (AS) 1, Disclosure of Accounting

Policies. By the principle of ‘substance over form’ in selecting accounting policies, enterprises are

required to give precedence to substance of a transaction over its legal form. In case of finance

leases, the lessee, despite not being legal owner, effectively enjoys all rights and accepts all

liabilities, usually attached with ownership. It is therefore rational for the lessee to recognise the

assets taken on finance leases as assets in its books.

It may also be mentioned that the paragraph 49(a) of the Framework for the Preparation and

Presentation of Financial Statement (issued 2000), defines assets as ‘resources controlled by an

enterprise as a result of past events from which future economic benefits are expected to flow to

the enterprise.’ It should thus be clear that necessary condition for recognition of an asset is

existence of control rather than ownership. The policy of recognition of assets taken on finance

leases is therefore consistent with the definition of asset as per the Framework, aforesaid.

Applicability of Accounting Standard

The Accounting Standard (AS) 19, Leases came into effect in respect of all assets leased

during accounting periods commencing on or after April 1, 2001 and was declared mandatory

from that date. The standard applies to all enterprises. The Level II and Level III enterprises

are however exempted from making certain disclosures. (See the Scheme for Applicability of

Accounting Standards) Any enterprise that does not make disclosures in pursuance of this

exemption, should disclose that fact.

The standard applies to all leases other than: (Paragraph 1, AS 19)

(a) lease agreements to explore for or use of natural resources, such as oil, gas, timber

metals and other mineral rights; and

(b) licensing agreements for items such as motion picture films, video recordings, plays,

manuscripts, patents and copyrights; and

Types of leases

For accounting purposes, leases are classified as (i) finance leases and (ii) operating leases.

A finance lease is a lease that transfers substantially all the risks and rewards incident to

ownership of an asset. An operating lease is a lease other than finance lease.

Whether a lease is a finance lease or an operating lease depends on the substance of the

transaction rather than its form. Paragraph 8 of the standard gives examples of certain

situations, which would normally lead to a lease being classified as a finance lease. These

are:

(a) The lease transfers ownership of the asset to the lessee by the end of the lease term;

(these situations may commonly arise in hire purchase)

(b) The lessee has the option to purchase the asset at a price which is expected to be

sufficiently lower than the fair value at the date the option becomes exercisable such

that, at the inception of the lease, it is reasonably certain that the option will be

exercised;

transferred; (Under US GAAP, a threshold limit of 75% or more of economic life is set.

See details at the end of chapter)

(d) At the inception of the lease, present value of the minimum lease payments amounts to

at least substantially all of the fair value of the leased asset; (Under US GAAP, a

threshold limit of 90% or more of fair value is set. See details at the end of chapter) and

(e) The leased asset is of a specialized nature such that only the lessee can use it without

major modifications being made.

Paragraph 9 of the standard describes certain situations, which individually or in combination

may indicate that the concerned lease is a finance lease. These are:

(a) If the lessee can cancel the lease and the lessor’s losses associated with the

cancellation are borne by the lessee;

(b) If gains or losses from the fluctuations in the residual value accrue to the lessee (for

example if the lessor agrees to allow rent rebate equaling most of the disposal value of

leased asset at the end of the lease); and

substantially lower than market rent.

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ACCOUNTING FOR LEASES (AS 19)