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Embedded lease — substance over form

what is an embedded lease

Adarsh Ranka

“The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form,” — a statement abstract from the Indian accounting standards that is seldom read and rarely followed. Accounting practices followed for ’Embedded lease’ reinforces the statement of ‘substance over form’.

The definition

International Accounting Standard 17 (IAS-17), on ‘Leases’, defines a lease as an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

Based on the ‘substance over form’ principle, transactions that in substance transfer the right to use an asset for an agreed period of time, in return for a series of payments, are accounted for as a lease transaction as per IAS-17, irrespective of the legal form of the arrangement.

International Financial Reporting Interpretations Committee (IFRIC) issued IFRIC-4 on ‘Determining Whether an Arrangement Contains a Lease’, which establishes the criteria that should be used to determine whether any arrangements have ‘Embedded lease’ that should be accounted for as per IAS-17.

Such transactions may include outsourcing arrangements such as the outsourcing of an entity’s data processing functions and take-or-pay contracts in which the purchaser must make specified payments regardless of whether the purchaser takes delivery of the contracted products or services.

The criteria for such evaluation are dependent on the use of a specific asset, explicit or implicit and the arrangement should convey a right to use the asset.

In most cases where it is a lease in legal form, it is simple to determine whether the transaction involves a lease transaction. To cite an example, the case where an entity intends to lease a building, the transaction being a lease transaction is evident from both form and substance perspective.

Closer evaluation needed

However, what we term as arrangements having ‘Embedded lease’ may require a closer evaluation. Here, based on the substance over form principle, a situation could arise where a transaction does not take the legal form of a lease, but in substance conveys the right to use an asset.

On concluding that the arrangement has an ‘Embedded lease’ within it, IAS-17 principles are applied. It would then need to evaluate whether it is a finance lease or an operating lease, which may result in a significant difference in the way accounting is done.

For example, a manufacturing company (purchaser) enters into an arrangement with a third party (the supplier) to supply a minimum quantity of

output needed for a specified period of time. The supplier designs and builds a facility to suit the purchaser’s requirement and the purchaser maintains control over key aspects of the facility operation. The purchaser will pay a fixed capacity charge and a variable charge on actual production.

Such an arrangement will be concluded as lease under IFRIC-4. It may also be termed as a finance lease under IAS-17, whereby the purchaser may need to capitalise or recognise an asset and a liability at an amount equal to the fair value of the underlying asset that was identified under IFRIC-4 and allocate the payments made towards lease payment of asset recognised. This may hold true even for certain arrangements where companies outsource work to Business Process Outsourcing (BPO) firms.

IFRIC-4 would have a significant impact on the real estate sector as the concept of ‘Embedded lease’ could convert companies with core activities such as manufacturing, BPO, etc. into leasing and real estate companies from a business activity perspective.

Tax perspective

‘Embedded lease’ accounting also needs to be viewed from a tax impact perspective. Leases in legal form are subject to certain indirect taxes in India, but ‘Embedded lease’ is currently not subjected to indirect taxes.

In fact the lessee in an ‘Embedded lease’ arrangement can seek benefits of tax holidays by providing outsourcing services to the lessor.

Given the above hair-splitting exercise, the standards may need to take a more pragmatic view where the substance may not have been intended and embedded derivative may not actually reflect the actual arrangement/understanding between the parties concerned. Even a normal sub-contracting arrangement may get trapped in the accounting complexities of embedded derivative though that may not have been intended/ reflect the actual arrangement.

The Institute of Chartered Accountants of India (ICAI) is pronouncing new standards and amending existing one’s to put Indian GAAP in line with International Financial Reporting Standards (IFRS).

IFRS is now a given from 2011. In the absence of specific guidance under Indian GAAP to account for such embedded derivatives, companies have been and will continue to adopt varied practices.

An interim guidance, while the Indian GAAP converges with IFRS, will be a welcome change and help companies abide by ‘substance over form’. Further it would help embedded transactions to see the light of the day rather than be submerged in other arrangements.

(The author is a senior professional in a member firm of Ernst & Young Global. The views are personal.)

(This article was published in the Business Line print edition dated November 17, 2008)

Category: Credit

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