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Expert Advisory Committee

Options: phrase case-sensitive

Query No. 3

Subject:
Accounting treatment of lease premium received on lease
of industrial plots as industrial estates. 1

A. Facts of the Case

1. A government company, registered under the Companies Act, 1956, is engaged in the business of developing industrial plots, leasing
them to industrial units and meeting their financial needs.

2. The company has developed various industrial plots, which were acquired through the Government. The company provides adequate
infrastructure facilities like construction of roads, drainage system, sewerage system, water distribution network, maintenance of the plots,
etc. The said plots are then leased out to various industrial units who construct buildings/sheds etc. The lease is given for a period of 99
years and a non-refundable lease premium amount is collected towards 100% of the estimated development expenditure besides a yearly
rental of Re 1/-.

3. The querist has stated that till 1988-89, the following accounting practice was followed:

(i) the acquisition cost of land as well as the development expenditure of the industrial estates were shown as ‘Current Assets’
and the lease premium received on allotment of the corresponding developed plots was shown as “Current Liabilities” in the
balance sheet.

(ii) The resultant profit or loss on such activity was ascertained on completion of the development of the industrial complex.

4. According to the querist, the above accounting treatment was changed in the financial year 1988-89, as per the advice of the Accountant
General (Commercial), to the understated method, which has been followed upto and including the year 2005-06:

(a) accounting for the cost of land as well as the development expenditure of the industrial estates as ‘Fixed Assets’,

(b) proportionate amount of the lease premium is accounted for as income of the concerned financial year,

(c) the balance of the lease premium is presented under ‘current liabilities’, and

(d) depreciation is charged to the profit and loss account at the relevant rates on the concerned assets.

5. During the supplementary audit for the financial year 2002-03, the Accountant General (Commercial) commented that the company was
not following the accounting practice as per an Opinion given by the Expert Advisory Committee of the Institute of Chartered Accountants
of India (Query No. 22 of Compendium of Opinions – Volume No. XX), wherein it was opined that in such cases, the cost of acquisition of
land and the relevant development expenditure should be treated as current assets till the plots are leased and after leasing of the plots, the
lease premium received should be recognised as income in the profit and loss account in the year in which the recognition conditions as laid
down in Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of India are fulfilled and the

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costs of acquisition of land and the development expenditure thereon should also be expensed in the same year.

6. The Accountant General (Commercial) had commented on the same issue for the accounting year 2003-04 and had stated that the current
liabilities and fixed assets were being overstated.

7. The Board of Directors of the company has discussed the issue and decided as below:

(i) That the matter regarding accounting treatment to be given in the books of account in respect of the plots/land allotted by the corporation
under the lease premium scheme for the period of 99 years be referred to the Expert Advisory Committee of the Institute of Chartered
Accountants of India for expert opinion.

(ii) That the matter be brought to the Board after receipt of the expert opinion.

(iii) That till such time, the present accounting treatment be continued in order to have consistency.

8. The querist has reproduced below the gist of the Opinion of the Expert Advisory Committee referred to in paragraph 5 above, for
immediate reference:

(a) The query was regarding a government company, which was in the business of developing industrial estates and housing
plots, including provision of amenities and infrastructure just like the company under consideration. The developed industrial
estates were given out on lease for 60 years for which the company was receiving a lease premium at the beginning of the
lease period. The lease premium was not refundable during the period of lease. However, the lease was transferable to any
other entrepreneur with the consent of the company. A nominal lease rent of Re. 1/- per annum was charged from the lessees
besides recovery of service and maintenance charges towards maintenance of the industrial estate.

(b) The lease premium was accounted as income at 1/60th each year and the balance lease premium was shown as ‘lease
premium received in advance’ under the head ‘current liabilities’. The leasehold land, and the land development expenditure
were shown as ‘Fixed Assets’. On objections raised by statutory auditors, the company started amortising the proportionate
land development expenditure during the operative period of lease and included the same under the head ‘Depreciation’.

(c) Considering the above basic facts, the Expert Advisory Committee was of the view that in respect of the lease agreements
for long periods, e.g., 60 years and 99 years, it is generally expected that on the expiry of the lease term, either the lease
period would be extended or the title will pass to the lessee at some agreed amount. This amounts to passing of the significant
rights of ownership in the land to the lessee. Thus, it would be in the nature of sale of plots and should be accounted for,
accordingly. This requirement, according to the Committee, is recognition of the principle of ‘substance over form’.

(d) The cost of land along with development expenditure should be reflected as a current asset and should be expensed in the
same year in which the revenue from the lease of plots is recognised as income keeping in view the matching principle.

(e) Also, as per Accounting Standard (AS) 9, ‘Revenue Recognition’, issued by the Institute of Chartered Accountants of
India (ICAI), the following three conditions are laid down for recognition of revenue:

(i) Performance of the act giving rise to revenue

(ii) Measurability of the revenue

(iii) Collectability of the revenue

(f) In the light of the above considerations, the Expert Advisory Committee opined that the lease of land should be treated as
sale. Thus, whole of the lease premium should be recognised as revenue in the year in which the three conditions as laid
down in AS 9 are fulfilled and the related costs of acquisition of land and development expenditure thereon should be
expensed in the same period.

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9. The querist has further stated that perusal of the lease deed of the company reveals certain important provisions which are enumerated
below (a copy of the deed has been separately provided by the querist for the perusal of the Committee):

(i) In fulfillment of one of its principal objects, the company has laid out the land into various plots, drains and for other
commercial betterment schemes for the benefit of the occupants of the plots so laid out. The company proposes to have
control over the amenities so created, such as roads, water supply, drainage, etc., so that these are distributed to the
industrialists in a reasonable and equitable manner. The company also proposes to allot the land on long lease for 99 years
inasmuch as it is felt that the characteristic and homogeneity of the industrial estate should not be destroyed. Also, the
intention of the company is that the leased land should be put to the exclusive use for industrial purposes and thereby
facilitating the implementation of the pattern of industrialisation that was envisaged. (Emphasis supplied by the querist.)

(ii) The lessee shall pay 100% of the estimated development expenditure as non-refundable premium in addition to paying
rent of Rs. 100/- for 99 years (Re. 1 p.a. for 98 years and Rs. 2 for 99th year) and service and maintenance charges as may be
intimated on a monthly basis.

(iii) In case the lessee violates any conditions of the lease deed, the company may determine the lease during the period of
lease and take possession of the said allotted plot together with the factory buildings and other buildings located on the same
and the lessee shall not be entitled to any compensation for any of the construction on the allotted plot or any refund of any
amount paid by the lessee by virtue of this deed. (Emphasis supplied by the querist.)

(iv) If the lessee, by any of his action, causes the land to be sold or attached, then the company may determine the lease and
take possession of the said property along with the buildings thereon as mentioned in the above paragraph. (Emphasis
supplied by the querist.)

(v) If any portion of land allotted to the lessee is found unutilised or in excess of the lessee’s requirements, then the company
may take over the unutilised or excess land and the proportionate non-refundable premium paid by the lessee for such land
shall be refunded to the lessee. (Emphasis supplied by the querist.)

(vi) On expiry of the lease term laid down in the lease deed, the new lease of the said plot for a similar period of 99 years
shall be entered into on such covenants and provisions, as contained in the original lease deed.

10. The querist has stated that the above clauses reveal the intention of the company to hold the said plots as its own fixed assets and the
agreement reveals that no significant rights of ownership pass on to the lessee, inasmuch as that the company retains the right to take over
the land with its buildings thereon, upon certain events taking place, even without compensation being payable to the lessee.

11. According to the querist, the condition, “performance of the act giving rise to revenue” is not absolutely fulfilled in this instance, as the
company retains the right of ownership and even eviction and repossession, and also the company retains the power to extend the lease for
another 99 years. Hence, in substance, it cannot be said that the significant rights of ownership have passed on to the lessee.

12. Besides, as per the querist, if the cost of acquisition of land and development cost thereon, are treated as current assets and expensed in
the same year in which the revenue from sale of plots is recognised, it leads to the anomaly that the fixed assets of the company are written
off, while the company retains the ownership rights on such assets which are only leased. According to the querist, this is not in accordance
with Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, or generally
accepted accounting principles. This accounting treatment will not reflect a true and fair view of the financial statements and would invite a
qualification thereon by the auditors.

13. The querist has further stated that accounting of the lease income fully in the year of receipt will also not be in accordance with the
principles of recognition of revenue laid down in AS 9, viz., measurability of revenue, as the lease income is paid in advance for 99 years
and if accounted in one year, will lead to lopsided presentation of income and non-matching of income with relevant expenditure like
depreciation on amenities and other infrastructure. In the view of the querist, this accounting treatment will not reflect a true and fair view
of the financial statements and would invite a qualification thereon by the auditors.

14. The querist has reproduced the professional opinion of the statutory auditors on this issue which is as follows:

“(i) … we are of the professional opinion that the accounting system followed by the company, i.e., accounting for the cost of
acquisition of land and development costs thereon and other infrastructure costs as fixed assets and accounting for the lease
premium received in advance as current liabilities and proportionate lease premium (1/99th) as income for the financial year
and charging off depreciation for the relevant assets to profit and loss account, is as per the generally accepted accounting

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principles and relevant accounting standards.

(ii) Besides, we are of the professional opinion, that the opinion of the Expert Advisory Committee of the ICAI should be
taken into consideration with all other relevant factors and that it is specifically mentioned that the opinion of the Expert
Advisory Committee is only that of the Expert Advisory Committee and does not necessarily represent the opinion of the
Council of the Institute of Chartered Accountants of India, which is binding on all institutions and members of the ICAI.”

B. Query

15. Considering the above factors, the querist has sought the opinion of the Expert Advisory Committee as to whether, on consideration of
the facts and circumstances of the case concerned, it is right for the company to continue its accounting practice of:

(a) recognising the cost of land as well as the development expenditure of the industrial estates as ‘Fixed Assets’,

(b) recognising the lease premium under ‘Current Liabilities’,

(c) recognising the proportionate amount of lease premium as income of the concerned financial year, and

(d) charging the depreciation to the profit and loss account at the relevant rates on the concerned assets.

C. Points considered by the Committee

16. The Committee notes paragraph 17(b) of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, issued by the ICAI, which
states as follows:

“17(b) Substance over Form

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.”

17. The Committee notes from the above that the transactions and events are accounted for and presented in accordance with their
substance, i.e., the economic reality of events and transactions and not merely with their legal form. The Committee notes from the ‘Facts
of the Case’ that the plots of land are given by the company on lease for a period of 99 years, which is renewable for a similar period. The
Committee is of the view that taking into account the long period of lease with renewability clause, and the prevalent commercial practices
in India in this regard, in substance, the lease of land in this case amounts to passing of significant rights of ownership to the parties
concerned. Thus, such a lease would be in the nature of sale of plots and should be accounted for accordingly. In this regard, the Committee
notes that the principle of substance over form is also recognised in Schedule VI to the Companies Act, 1956, which requires leaseholds to
be shown as fixed assets of the lessee and not of the lessor. The Committee further notes from the ‘Facts of the Case’ that the leasing of
industrial plots constitutes an ordinary activity of the company; hence, land along with the development expenditure incurred thereon
should be accounted for as ‘Current Assets’ rather than ‘Fixed Assets’. Accordingly, no depreciation should be charged on such assets.
These current assets should be expensed in the year in which revenue from the leasehold premium is recognised, as discussed in the
following paragraphs.

18. The Committee also notes that the querist has argued in paragraph 9(iii) above that the company can take back the possession of the
leased land, in case the lessee violates the conditions of the lease deed, or causes the land to be sold or attached, or keeps the land
unutilised, etc. The Committee is of the view that such terms and conditions under the lease deed are generally inserted so as to regulate the
use of industrial plots for specified purposes only and for their optimum utilisation. The Committee also notes that the company also
reserves the right of taking the possession of factory buildings and other construction on land, which are not even owned by the lessors. In
the view of the Committee, this does not represent the intention of the company to hold them as its fixed assets. Similarly, the Committee is
of the view that the above-mentioned conditions in case of lease of land, in no way, represent the intention of the company to hold the plots
as its own fixed assets as defined in Accounting Standard (AS) 10, Accounting for Fixed Assets, issued by the Institute of Chartered
Accountants of India. Accordingly, the contentions of the querist, as stated in paragraphs 11 and 12 above are also not tenable as the
significant rights of economic ownership of the land leased for a long period of 99 years, do not vest with the company.

19. Regarding the recognition of revenue, the Committee notes from the lease deed supplied by the querist, separately that the upfront lease
premium comprises upfront leasehold premium on account of the acquisition of land and on account of development expenditure, which is
collectively referred to as ‘estimated development expenditure’. As far as premium in respect of land is concerned, it should be recognised
as revenue in the profit and loss account in the year in which the recognition conditions laid down in paragraph 11 of AS 9 are met. The
revenue from development expenditure such as expenditure on construction of roads, drainage system, sewerage system, etc., should be
recognised proportionately over the term during which the development activity is carried on, on the basis of stage of completion, every

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year. The Committee is of the view that this manner of recognition of revenue on account of upfront lease premiums related to estimated
development expenditure would lead to matching of revenue with the cost. As far as the expenditure incurred in future on services and
maintenance of land is concerned, the same will be matched with the services and maintenance charges obtained by the company.

D. Opinion

20. On the basis of the above, the Committee is of the opinion that it is not right for the company to continue its accounting practice of:

(a) recognising the cost of land as well as the development expenditure of the industrial estates as ‘Fixed Assets’,

(b) recognising the lease premium under ‘Current Liabilities’,

(c) recognising the proportionate amount of lease premium as income of the concerned financial year, and

(d) charging the depreciation to the profit and loss account at the relevant rates on the concerned assets.

The company should follow the accounting policy as suggested by the Committee in paragraphs 17 and 19 above.

1 Opinion finalised by the Committee on 27.3.2006

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