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Meaning
A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred. This is based on the concept of substance over form. An operating lease is a lease other than a finance lease.
Other symptoms
If the lessee can cancel the lease, the lessors losses associated with the cancellation are borne by the lessee; Gains or losses from the fluctuation in the fair value of the residual fall to the lessee (for example in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and The lessee can continue the lease for a secondary period at a rent which is substantially lower than market rent.
Valuation problem
Suppose , fair value of an asset under finance lease is Rs. 775000 and the lessee agrees to pay @ Rs. 200000 p.a . His incremental borrowing cost is 10%. Implicit interest rate is 10.42% . See xlsworksheet. Present value of discounted cash flow Rs.758157 > 750000 . Then the lessee should recognise asset and liability at fair value. What if the fair value is Rs. 750000. Then the lessee should account for the obligation at a higher amount. But the leasehold asset should be recognised at fair value. The lessee should then recognised loss at the inception of the transaction.
Para 11 of AS-19
At the inception of a finance lease, the lessee should recognise the lease as an asset and a liability. Such recognition should be at an amount equal to the fair value of the leased asset at the inception of the lease. However, if the fair value of the leased asset exceeds the present value of the minimum lease payments from the standpoint of the lessee, the amount recorded as an asset and a liability should be the present value of the minimum lease payments from the standpoint of the lessee. In calculating the present value of the minimum lease payments the discount rate is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessees incremental borrowing rate should be used.
Para 11 of AS-19
It is deviating from by cash value valuation method while assessing obligation under lease .
Manufacturer Lessor
Distinguish between profit arising out of outright sale and finance charge. Profit airising out of outright sale should be recognised at the inception of lease.
Lessors Receivable
It is present value of future cash flow. If that is so what should the be the discount factor? Current asset should be booked at fair value which is can be arrived only if latest incremental lending rate is used.
2002-03
Lease Rentals in respect of assets taken on 'Operating Lease' are charged to the Profit and Loss Account. Assets taken on Finance Lease are accounted for as assets of the Company. Lease rentals payable are apportioned between principal and interest using the internal rate of return method and finance charge is recognised accordingly.