INTRODUCTION
In some situations, a lease may effectively represent an in-substance purchase. The distinction between a lease and an in-substance purchase may have a significant impact with respect to the accounting, if variable payments are involved as well as with respect to presentation and disclosures. This distinction is critical in the case of aircraft, ships, etc. This article delves into this issue and provides relevant guidance.
FACTS
Consider the following fact pattern:
1. As per local safety legislation, Machine X can be used only for ten years, after which it must be sold to recyclers for scrapping.
2. Ze Co (hereinafter referred to as ‘Lessee’) acquires Machine X on lease for a non-cancellable lease term of ten years from Ed Co (hereinafter referred to as ‘Lessor’).
3. Fixed lease payments are made at the beginning of each year over the lease term. There are no variable lease payments.
4. As per the lease agreement, the Lessee has an option to buy Machine X at INR 1,000 at the end of the tenth year.
5. The legal title of Machine X is transferred to the Lessee at the end of the tenth year, if the Lessee exercises the option to purchase Machine X.
6. The fair value of Machine X if it is to be sold as scrap is likely to be several times more than INR 1,000.
7. The Lessor is not responsible for any malfunctioning of the Machine X during the lease period.
Whether this arrangement would constitute an in-substance purchase or lease from the perspective of the Lessee? How does the Lessor account for such a transaction?
References to Accounting Standards
IFRS 16 Leases provides guidance in the Basis of Conclusion and is reproduced below. It may be noted that Ind AS 116 Leases does not include any Basis of Conclusion, but the Basis of Conclusion under IFRS can be applied as the best available guidance.
IFRS 16 Basis of Conclusion
BC138 The IASB considered whether to include requirements in IFRS 16 to distinguish a lease from the sale or purchase of an asset. The IFRS Interpretations Committee had received questions about whether particular contracts that do not transfer legal title of land should be considered to be a lease or a purchase of the land.
BC139 The IASB decided not to provide requirements in IFRS 16 to distinguish a lease from a sale or purchase of an asset. There was little support from stakeholders for including such requirements. In addition, the IASB observed that:
a. the accounting for leases that are similar to the sale or purchase of the underlying asset would be similar to that for sales and purchases applying the respective requirements of IFRS 15 and IAS 16; and
b. accounting for a transaction depends on the substance of that transaction and not its legal form. Consequently, if a contract grants rights that represent the in-substance purchase of an item of property, plant and equipment, those rights meet the definition of property, plant and equipment in IAS 16 and would be accounted for applying that Standard, regardless of whether legal title transfers. If the contract grants rights that do not represent the in-substance purchase of an item of property, plant and equipment but that meet the definition of a lease, the contract would be accounted for applying IFRS 16.
BC140 IFRS 16 applies to contracts that convey the right to use an underlying asset for a period of time and does not apply to transactions that transfer control of the underlying asset to an entity – such transactions are sales or purchases within the scope of other Standards (for example, IFRS 15 or IAS 16).
ANALYSIS
When assessing the nature of a contract, an entity should consider whether the contract transfers control of the underlying asset itself as opposed to conveying the right to control the use of the underlying asset for a period of time. If so, the transaction is a sale or purchase within the scope of other standards (e.g., Ind AS 115 Revenue from Contracts with Customers or Ind AS 16 Property, Plant and Equipment). Consequently, if a contract grants rights that represent the in-substance purchase of an item of property, plant and equipment, such transaction may need to be presented as the purchase of the underlying asset (regardless of whether legal title transfers) either on deferred terms if entered into directly with the manufacturer or dealer of the asset, or together with the provision of financing if entered into with a financial institution which purchases the underlying asset on the entity’s behalf from a designated supplier.
Ind AS 115.33 defines control of an asset as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset. The benefits of an asset are the potential cash flows (inflows or savings in outflows) that can be obtained directly or indirectly. When evaluating whether a customer obtains control of an asset, an entity shall consider any agreement to repurchase the asset (see Ind AS 115.B64–B76). In determining whether an agreement is a sale / purchase agreement or a lease, the appropriate criteria to be used are those shown in Ind AS 115 in relation to the transfer of control.
Additionally, if retaining title of the asset has no substance, there is sympathy to treating the transaction as an in-substance purchase of PP&E (Ind AS 16). However, if there is substance to the title of the asset remaining with the supplier, and ownership is only transferred at the end, Ind AS 116 accounting would be more appropriate as the customer has right-of-use but does not have ownership. If variable lease payments are present in the agreement, the supplier / lessor retains some risk which may point towards lease accounting.
Typically, in land use rights, where the seller retains title and there is no option for the Lessee to purchase the land, the author believes that the title would be critical in evaluating whether the arrangement is a lease or an in-substance purchase of land. For example, in a 99-year lease with no option to purchase the land at the end of the lease term, or option to purchase the land at its then fair value, it is difficult to think someone has sold the land because, even after 99 years that land is very likely to have significant value which will not be ‘kept’ by the buyer. In contrast, lease of LED lights to a retail department store may constitute an in-substance purchase for the store because the value of the LED lights is in its usage, rather than its value at the end of its useful life. So, invariably, it boils down to the assessment of significance of title.
CONCLUSION
In the above fact pattern, the effective utility of Machine X is its usage over ten years, after which it is sold as scrap. There is a purchase option at the end of the lease term that is most likely to be exercised by the Lessee, as the Lessee will stand to benefit from exercising that option. Lastly, it appears that the Lessor retains no risk as there are no variable payments in the arrangement nor is the Lessor responsible for malfunctioning of Machine X. The Lessee retains all the risks and rewards in substance and the absence of legal title during the lease term should not preclude the Lessee from classifying Machine X as an in-substance purchase rather than as a lease.
From the Lessor’s perspective, the arrangement will constitute a sale of Machine X under Ind AS 115 since the control criterion under Ind AS 115.33 would be met in this case. In determining the transaction price of the sale, the Lessor will have to separate the financing component and record the same as financing income over the lease period.
