The Hindu Business Line : How straight are your leases?

A recent ICAI Expert Advisory Committee (EAC) opinion requiring straight-lining of operating lease rentals has stirred up a hornet’s nest. In the given case, the initial term of the lease was three years and further renewable at the sole and exclusive option of the lessee for two further terms of three years each.

The EAC opined that the straight-lining was required for a total of nine years, which resulted in a huge lease equalisation liability and charge to income statement, since there was periodical escalation built over those years.

The EAC rejected the view that the scheduled rent increases are in response to expected future increases in rentals in general and are costs of those years. In doing so, the EAC chose to ignore the commercial and contractual terms between the lessor and the lessee.

Recognising future costs

Straight-lining results in recognising future costs. When a purchaser makes an upfront non-cancellable commitment to purchase goods each year from a seller with a 10 per cent increase over the previous year’s rate, one does not straight-line the cost of purchase over those years.

Therefore if straight-lining is not required as a principle in the framework or by other standards, then it is inappropriate to apply it selectively in the case of leases.

More importantly AS-19 itself does not require straight-lining of maintenance expenses which are part of the lease contract. It is beyond comprehension as to why rental expenditure should be treated any different from other expenditure that an organisation incurs. Conceptually it does not make much sense.

A point to be noted is that straight-lining under the standard was incorporated as an anti-abuse measure against rent-free periods. Thus if a building is taken on operating lease for three years, with zero rent in the first two year and rent of Rs 3 lakh for the third year, the standard would require Rs 1 lakh to be charged each year. This is fair. However, to require straight-lining when there is no indication of deliberate ballooning is unfairly stretching the argument for straight-lining.

An interesting comparison would be to look at the standard on depreciation, which permits the written-down-value method and other methods such as unit of production method. Straight-lining is one of the permissible methods but not the only method. To impose straight-lining restriction for purposes of leasing seems inappropriate.

Deferred equalisation

The straight-lining of lease rentals would result in a deferred equalisation which may be a liability or an asset. The problem with deferred equalisation is that it does not fulfil the definition of an asset or liability under ‘The Framework for the Preparation and Presentation of Financial Statements’ issued by the Institute of Chartered Accountants of India.

It begs the question therefore that if deferred equalisation is not an asset or liability as defined under the Framework, then what is it doing in the balance-sheet?

Another criticism of the EAC opinion is that it does not consider time value of money, which is inconsistent with the requirements of various other standards which consider time value of money. More importantly, the standard ignores the fact that as time passes costs may go up or go down and so does the revenue. The cost of operating in 2007 would always be different from the cost of operating in 2008. To try and straight-line the cost (in the case of lessee’s) selectively for leases is a violation of sound accounting principles.

In India, it may be fair to state that one of the reasons for lease rentals to increase is inflation. Now if the scale up on the rentals was based on an inflation index rather than a fixed amount, the scale up would be treated as contingent rentals under AS-19 and accounted for when the contingent rentals become due. Would it be fair not to allow this treatment, just because the lease rental scale up is fixed instead of linked to an inflation index? This is a violation of a principles-based approach, which is so fundamental to IFRS and Indian GAAP.

It may be noted that the straight-lining rule applies not only to lessee but also to the lessor. However, unlike the lessee, the lessor as a matter of prudence may be precluded from straight-lining lease revenue beyond the non-cancellable lease period, since AS-9 would also apply. In other words, the straight-lining rule may apply differently to the lessor and the lessee and, hence, another argument against the EAC ruling.

Binding on the auditor

The EAC opinion is binding on the auditor, however, but has no jurisdiction over companies, since it is not a mandatory accounting standard. This situation may create conflict between the auditor and auditee. There is a high probability that a larger part of the industry and the profession would either not be aware of the EAC ruling and its implication or may have chose to disregard it. Would it not have been wise for EAC to consider the views of the industry/profession before issuing such an opinion?

It may be noted that the equalisation adjustment will open up a Pandora’s box in regards to its implication on service tax, FBT, TDS, income-tax deductibility, determination of managerial remuneration, etc? It is unclear why there should be an over-emphasis on straight-lining (for leases), other than for psychological reason that if it is not straight, it has to be crooked.

(The author is Partner, Ernst & Young Pvt. Ltd. The views are personal)

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