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Total Number of Subscribers: 426 |
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Date: 5 May 2008 |
Compiled by Mr. M. Sathya Kumar |
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Straight-line accounting of lease
rental Introduction
: Accounting Standard 19 (AS-19) deals with the subject of
accounting for lease rental from the standpoint of both, the lessor and the
lessee. AS-19 classifies leases mainly into two categories : Finance
Lease and Operating Lease (OL). Different accounting treatments are
prescribed in respect of rental from finance lease and OL. Amount of rent in an OL is fixed by mutual agreement between the
parties to a lease transaction. Varying rents are often provided in the
agreement. Mostly, lease rental amounts are higher in the initial years and
they decrease in later years. This pattern of rent fixation is used to
recognise the fact that the underlying asset under lease is more utile in the
beginning of the lease period for its being new and fresh, and becomes less and
less utile with the passage of time. In some cases, particularly in the cases involving leases of
immovable properties, it is also observed that relative lease agreements
provide for increases in lease rental with the passage of time. Thus, we can
have situations with decreasing and increasing lease rentals, and in both the
cases, we can say that the lease rentals are not evenly spread over the
period of lease. The question is : how to account lease rental, where
lease rentals vary over the period of lease, in the books of both, the lessor
and the lessee ? In this regard, AS-19, in paragraph 23, says the following in
the context of operating lease from the standpoint of the lessee :
Paragraph 24 of AS-19 explains the previous paragraph and takes
the theme forward by saying that lease rental will be accounted on a
straight-line basis, unless another systematic basis is more representative
of the time pattern of the user, even if the payments are not on that basis. Paragraphs 23 and 24 relate to payments of lease rental and view
the matter from the standpoint of the lessee. The same view is taken in
paragraph 40 of AS-19 when the matter is viewed from the standpoint of the
lessor, though, it would be interesting to notice the difference in language
when the paragraphs relating to lessees and lessors are compared. This will
be done in the later part of this Article. One can see that AS-19 suggests a treatment of accounting in
respect of lease rental in an OL, which treatment is devoid of the terms of
the agreement of lease. AS-19, in substance, states that expenditure and
income, both, resulting from payments and receipts under an OL, should be
recognised on a straight-line basis, unless another systematic basis is more
representative of the time pattern of the user’s benefit. The only caveat is that when it comes to dealing with the case
of a lessor, from paragraph 40 of AS-19 it can be inferred that it supposes
the time pattern to be such in which benefit derived from the use of the
leased asset is diminished. Such supposition is not made when the matter is
viewed from the standpoint of the lessee. The Expert Advisory Committee (EAC) of the ICAI had an occasion
to deal with a query, published in the ICAI’s
journal of July, 2007. In that case the query related to an OL of an immovable
property. The lease agreement provided that lease rental would stand
increased after a certain period. It was reasonably certain that the lease would get renewed and
the lessor would be able to realise such increased rental. The question was,
whether the straight-line accounting of lease rental would be followed,
especially when it would account higher income in the beginning of the lease
period than the income that would arise under the lease agreement. The EAC advised that based on the facts of that case, the income
should be recognised on a straight-line basis. It is proposed to critically examine the opinion of the EAC on
leases in respect of immovable property where agreements provide for
periodical escalations of lease rental during the term of the lease. Defining issues : It would be advisable to define the issues before they are
picked up for discussion for a better comprehension of the issues. What is the general rationale behind the recommendation of
accounting lease rental on a straight-line basis ? Is AS-19 fully applicable in case a lease is an OL in respect
of an immovable property, particularly when the terms of the lease provide
for incremental rental over periods ? What are the accounting implications when the opinion of the
EAC is followed? How would lease rental accounted following AS-19 in an OL in
respect of an immovable property impact the computation of taxable income,
especially when the terms of the lease provide for periodical escalations of
rental during the tenure of the lease ? Addressing the issues as defined : Here, it must be said that much of what will follow relates to
the accounting of lease rental on a straight-line basis in an operating
lease. It is the issue of accounting lease rental on a straight-line basis
that begets further issues when AS-19 is applied to operating leases in
respect of immovable properties, especially when the terms of the lease
provide for periodical escalations of lease rental. The opinion of the EAC
has just triggered the discussion; it is not the generator of the issues. It seems that AS-19 postulates a situation in operating leases
in which the benefits derived from the use of the leased asset are diminished
over the period of lease. Though this is not made clear in paragraphs 23 and
24, it is made clear in paragraph 40 of AS-19. This paragraph deals with
accounting of lease rental in an OL from the standpoint of the lessor.
Paragraphs 23 and 24 of AS-19 do not use the words ‘benefit derived from the use of the leased asset is diminished’,
which
are used in paragraph 40. The difference in language of paragraphs 23 and 24
on the one hand and of paragraph 40 on the other hand has, perhaps, to do
with the fact that paragraphs 23 and 24 of AS-19 deal with expenditure on
account of lease rental, and it is only proper that expenditure is linked
with the associated benefits; if benefits are more in an accounting period,
higher lease expenditure is accounted, and if the benefits are lower in an
accounting period, lower lease expenditure is accounted. The same linking of
benefits is not required when the matter is considered from the standpoint of
the lessor, for he has to account income. Paragraph 40 seems to visualise the following situations in an
OL :
Paragraph 40 suggests adoption of a straight-line basis of
accounting for lease income in situations visualised in (b) and (d) above. In
situation (a), it suggests a method appropriate which is representative of
the time pattern in which benefit derived from the use of the leased asset is
diminished. Situation visualised in (c) is the perfect situation where the
lease rentals reflect the time pattern of diminishing benefits derived from
the use of the leased asset. Lease rental will be accounted as is provided in
the terms of the lease. strict reading of paragraph 40 suggests that it does not seem to
visualise a situation of increasing rental over the period of lease, whether
benefits from the use of the leased asset increasing or diminishing or
remaining constant. Therefore, in a case involving increasing rental, which
in no case can represent a time pattern in which benefit derived from the use
of the leased asset is diminished, the only choice one is left with is to adopt
the straight-line basis of accounting for lease rental as income. If the lease rentals as agreed upon are higher in the beginning
of the lease period and declining with the passage of time, or are constant,
the lessor will adopt the straight-line basis of accounting. This may reflect
lower income than the income agreed upon in the beginning of the lease period
or the same income as agreed upon, and thus, may meet with the requirement of
the principle of prudence. However, if in his case, the lease rentals as
agreed upon increase with the passage of time, that is, rentals are lower in
the beginning of the lease period and increasing with the passage of time,
then the real problem arises. Why is a feeling developed that paragraph 40 of AS-19 does not
seem to visualise a situation of increasing rental over the period of an OL ?
One may notice the use of the word ‘more’ in
paragraph
40 over which emphasis is supplied by showing it in dark letters in a
preceding paragraph. The use of the word ‘more’ indicates
that the method to replace the straight-line basis of accounting should be more
representative of the time pattern in which benefit from the leased asset is diminished. This would seem to indicate that it is believed that usually the
benefits from a leased asset diminish with the passage of time and therefore
what is usually pre-supposed are the declining rentals which reflect the
accurate time pattern of use of the leased asset. However, if the lease
agreement does not provide for such declining rental, or provides, instead,
for increasing rentals, then, in the absence of any other better alternative, the straight-line
basis of accounting should be followed. Thus, what it means is that the
straight-line basis of accounting is not the method of first choice. It is only when there is no system of accounting for rental
which better reflects the time pattern of use of the leased asset that the
straight line basis of accounting for lease rental is to be followed. This is
so far alright, but it does not address the issue of increasing rental, for
the whole paragraph 40 of AS-19 seems to have been drafted keeping declining
rental in mind. It is here commended for a better comprehension of the issues on
hand that though paragraphs 23 and 40 are slightly differently worded, they
must be construed similarly, since they relate to the same subject matter,
only viewed differently from the standpoints of the lessor and the lessee;
paragraph 23 views the matter from the standpoint of the lessee, whereas
paragraph 40 views the same matter from the standpoint of the lessor. Once we agree on the proposition that paragraphs 23, its
extension in paragraph 24 and paragraph 40, all postulate a possibility of a
situation of diminishing benefits and decreasing returns derived from the use
of the leased asset, and do not postulate a situation of increasing benefits,
then it seems inappropriate to apply these paragraphs to a situation of
escalating returns, with or without associated diminishing benefits derived
form the leased asset. The question is : then how does one deal with the situation of
escalating lease rentals ? The answer could be: No way. Perhaps AS-19 is not
intended to apply to operating leases with varying rentals, where rentals
increase with the passage of time, or that AS-19 falls short to cover such a
situation. Moreover, there is still the fundamental question whether AS-19
can at all apply to the whole of rent in respect of lease of an immovable
property ? The fact that such leases usually provide for increasing rental
over the period of lease further compounds the problem. It is a common
knowledge that real estate prices show a trend of increasing prices over
periods. Further, it is also a common knowledge that a large component of
cost of an immovable property comprises the cost of land embedded in the
immovable property. That is, when a building sells, say, for Rs.1 crore, it
is not that the seller tries to get the value of superstructure; it is rather
that he tries to get the value of the land. Thus, when rent of an immovable property is fixed, it accounts
for a large part the value of the land. Rental of a building can be split
into: rental attributable to the land component and rental attributable to
the superstructure. If this is done, then AS-19 becomes inapplicable to the
rent attributable to the land. (It is provided in AS-19 itself that it does
not apply to lease agreements for use of lands). Now the question is : merely because the amount of rent
is comprehensively fixed for both, the land and the superstructure, can it be
said that there is no rent attributable to the use of the land ? The answer is perhaps, no. Then, if there is a substantial rent
towards the use of land, it may make AS-19 inapplicable at least to that part
of the rent. This view is also based on the other view that accounting for a
transaction should be made keeping in mind the substance over the form of the
transaction. This principle is laid down in AS-1. In view of the above, it seems it would be inappropriate to
apply AS-19 wholly to leases for use of immovable properties and particularly
when the terms of lease provide for increasing rentals. The opinion of the EAC recommends straightline basis of
accounting for lease rental arising from leases of immovable property, even
in cases where lease rentals increase over period of lease. This may give
rise to the creation of an asset in the form of lease rental receivable in
the initial years, if increasing rents over the tenure of lease are provided
in the lease agreement. The asset, when created, will be a fictitious asset. The asset
may not strictly fit in the meaning of the term ‘Asset’ used in financial statements, since this asset may have
resulted because of advance recognition of an income yet to arise. For example, rentals for the first, second and third years are
fixed at Rs.75, Rs.100 and Rs.125. The total rental is Rs.300. As per AS-19,
the income that will be recognised in each year will be Rs.100 against Rs.75
actually receivable in the first year. This excess Rs.25 recognised as income
will appear as an asset and will be adjusted in the third year against the
actual income of Rs.125, thus, equalising income in each year. The next question to be addressed is : How the
straight-line basis of accounting for lease rentals under operating leases
should impact income-tax assessment ? In the case of increasing rental in respect of operating leases,
AS-19 would require recognition of unearned, unaccrued income in the initial years.
The assessee obviously would claim in his income tax assessment that he
cannot be taxed on income that has not accrued to him. To this, the assessing
officer (AO) may contend that the issue whether an income has accrued or not
is decided not only by the terms of an agreement, but also by the method of
accounting followed, particularly when such method is backed by an accounting
standard. Thus, here will be a case where the assessee would be running away
from application of an accounting standard, whereas the AO may try to enforce
the accounting standard. If it is a case of a lessee with diminishing rentals provided in
the agreement, he will book lower lease rental as expenditure in the initial years
in order that lease rentals may equalise over the entire period. This may raise his book income in the initial years, and may
give the AO an opportunity to tax such book income in place of the actual
income. Needless to say that lessors and lessees, when they book income
or expenditure in accordance with AS-19, which income or expenditure is be
different from income or expenditure as per the relative agreements, may face
problems in income tax assessments. The lessee may have booked lower expenditure in the initial
years in the case of declining rental, which may suit the AO to accept it,
but tax may not be on real income of that particular year. In a similar case,
the lessor may book lower income, which may not suit the AO whomay propose
addition to income. The Supreme Court recently observed in the case of J.
K. Industries Ltd. (2007) 165 Taxman 323, “Main object sought to be achieved by Accounting Standards which are
now made mandatory is to see that accounting income is adopted as taxable
income and not merely as the basis from which taxable income is to be
computed.” Thus, it seems a reliance on accounting standards to determine
taxable income may be justified if there is no explicit contrary provisions
of law. At the same time, u/s.5 read with S. 4 of the Income-tax Act, 1961,
an income should have accrued or arisen or should have been received before
it can be brought to tax. Can the lessor, where lease rentals increase in later
years, say that notwithstanding AS-19, and notwithstanding rent equalisation
recommended therein, it is only so much of rental income as has really
accrued that can be brought to tax ? The author feels he can so contend, for, in the case of
increasing rental, the right to receive higher rental arises or accrues only
in terms of the agreement between the parties, and since the rental that
accrues in the initial years under the agreement will be lower than the
rental income disclosed in accounts, he may exclude the excess for the
purpose of taxation. The issue, though, is contentious and the Author’s view is not free from doubt. It may not be out of place to discuss the case decided
by ITAT in Dy. CIT v. Nagarjuna Investment Trust Ltd., 65 ITD 17. In this case, the
assessee had provided in the agreement of lease that the amounts towards
income received from the lessee would be equal in each instalment received
form the lessee. However, while accounting for income in the books of
account, it worked out interest from each instalment on the basis of
outstanding balances. This method resulted in disclosure of higher income in the books
in the initial years than had been agreed under the agreements. While filing
the return, the assessee excluded income booked that was in excess of the
income arising as per the agreements. In support of the claim, it argued that though a particular
income was booked by application of a method of accounting and though that
method was acceptable u/s.145, yet, that income had not really ‘accrued’, for the fact of accrual has to be decided in
accordance with the terms of the relevant agreement, and, therefore, S. 145
cannot override S. 5 and S. 4 of the Income-tax Act, 1961. The ITAT accepted
the arguments. Conclusions : There is a plethora of instances where accounting and taxable
income can differ. AS-19 may provide one more instance and, for that matter,
one more avenue for litigation. The straight-line basis of accounting for income recommended in
paragraph 40 of AS-19 seems designed more to take care of decreasing rental
which again seems to recognise decreasing benefits derived from use of the
leased asset over years. This supposition would usually hold good for lease
of movable and depreciable assets which are subject to high wear and tear,
like cars, machines, etc. Viewed with this angle in mind, it makes sense for the lessor to
recognise lower income in the initial years by adopting straight-line basis
of accounting or at least account decreasing income every year. This may also
be in consonance with the principle of prudence which requires that income
should be booked only when it is realised or its realisability is certain.
Requiring the lessor to book higher income in the initial years of lease in
case the lease rentals increase over years, would amount to negate the
principle of prudence. Lease of a building poses more problems because part of rent is
attributable to the use of the land component. Such part of the rent at times
is sizable and application of AS-19 to the whole rent may perhaps be
inappropriate. Coutesy
: Article by Kirit S. Sanghvi Chartered Accountant |
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