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Hospitality Industry - Does handing over business operations and premises, equate to lease, or hiring a sub-contractor?

Gautam Gupta 
on 26 September 2020

LinkedIn


There are certain places with restrictions to lease the premises, only the owner of the premise can use the premise to run the business. In such a case, the lease agreement is framed in such a way where agreement states that the owner of the premises is running the business on the premises but such owner has hired a third party to run the business, however substance of the transactions are different, hence the complex accounting issues arise.

The important consideration here is to analyze whether such a third party is the principal or agent for running such operations or whether such an agreement is a sub-contracting agreement or a lease agreement.

This article aims to explain such an issue with the help of the below example.

Background:

ABC Limited (ABC) has entered into an agreement with XYZ Pvt Ltd (XYZ) to operate and manage the restaurant. XYZ Ltd is the owner of the premises "Shop No. AB-16, F-land".

XYZ Ltd is desirous of operating the restaurant under the brand name "Florence" at the said premises, but due to lack of personal skill and experience in running the restaurant, XYZ Ltd handed over the management, control, and operations of the said premises for running the restaurant to ABC Limited. Further, it is agreed between the parties that ABC Limited shall have at all times the final control, discretion, and authority with respect to the operations and management of the restaurant. Both parties agreed to such a mechanism for a period of 5 years.

Hospitality Industry - Does handing over business operations and premises, equate to lease, or hiring a

Brand Name: The restaurant shall all times, during the term of the agreement, be designated and operated under the name of the "Florence". Ownership and right to use the brand name shall always belong to ABC Limited.

Billing arrangement: Invoice to the end customer will be generated in the name of the XYZ Ltd. Revenue generated shall be directly transferred into the separate bank account opened in the name of the XYZ Ltd, such account shall be jointly operated by the parties.

Funds from such an account can be used towards the payment of indirect tax liabilities (Such as GST, etc), Minimum guaranteed amount / pre-determined percentage of net sales to XYZ Ltd. Balance amount shall be transferred to ABC Limited.

Sole roles and responsibilities of ABC Limited at its own cost are to:

a) Build and operate the restaurant,

b) Leases or purchase of equipment’s, plant & machinery, furniture & fixtures,

c) Marketing strategy,

d) Purchase of goods and services and other supplies,

e) Recruitment of employees, etc.

f) Determination of the credit policies;

g) determination of the menu, prices, rates, etc.

Revenue Sharing terms and security deposit: USD 2 lac per month or 7% of the revenue each month whichever is higher shall be paid to the XYZ Ltd. During the term of the agreement, such payment continues to be made even if the operations of the restaurant are discontinued for any reason. ABC Limited has paid a certain amount of security deposits to XYZ Ltd.

Issue:

  • Whether ABC Limited is acting as a principal or an agent for delivering the goods and services to the customers?
  • Whether the agreement contains a lease within the meaning of Ind AS 116?

Assessment of the principle Vs agent relationship:

As the primary responsibility of operating the restaurant is with ABC Limited as XYZ Ltd has handed over the operations and management of the restaurant to ABC Limited, additionally, ABC Limited is responsible for making all the decisions in relation to the framing business plans and operations policies.

ABC Limited is responsible for fulfilling the performance of goods and services, inventory risk lies with ABC Limited, and latitude of determining the prices of goods and services lies with ABC Limited. (for details, refer above analysis section).

Further to state, ABC Limited has committed to making a payment of a minimum guaranteed amount to XYZ Ltd during the term of agreement even if the restaurant is making losses or closed down. This is indicating that XYZ Ltd is receiving consideration towards allowing ABC Limited to make use of the premises to run the restaurant and XYZ Ltd is not participating in the profit/loss from the operations of the restaurant as the XYZ Ltd is entitled to receive consideration in the form of the minimum guaranteed amount and a certain percentage of the revenue generated from the restaurant (i.e. consideration to XYZ Ltd is not based on profit/loss generated).

Additionally, in case the restaurant’s operations are closed down or sold to the third party, then in such case, XYZ Ltd is not entitled to receive the amount from such winding-up proceeds as the brand "Florence" is owned by ABC Limited.

Considering the above, ABC Limited is a principal as it is the only party responsible for fulling performance obligations and bearing risks and rewards in relation to the operations of the restaurant. Therefore, ABC Limited shall recognize revenue on a gross basis instead of recognizing it as net of the amount paid to XYZ Ltd.

An assessment of whether the agreement contains a lease under Ind AS 116:

A contract is, or contains, a lease if there is an identified asset and the contract conveys the right to control the use of the identified asset for a period in exchange for consideration. An entity assesses whether a contract is, or contains, a lease at the inception date. The inception date is the earlier of the date of a lease agreement and the date of commitment by the parties to the principal terms and conditions of the lease.

Caption

Author’s View

Identified Assets: An asset can be identified either explicitly or implicitly. If explicit, the asset is specified in the contract; if implicit, the asset is not mentioned in the contract but is implicitly specified when the supplier makes it available to the customer. Both cases could result in an identified asset.

Substantive substitution rights

Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive if both of the following conditions are met:

  • The supplier has the practical ability to substitute alternative assets throughout the period of use; and
  • The supplier would benefit economically from the exercise of its right to substitute the asset.

In the given case, the agreement specified the property to be used for operating the restaurant. Hence, the asset is explicitly identified under the agreement.

Furthermore, the supplier of the asset does not have any substitution right of such specified asset.

A contract conveys the right to control the use of an identified asset if the customer has both the right to obtain substantially all of the economic benefits from the use of the identified asset and the right to direct the use of the identified asset throughout the period of use.

A customer has the right to direct the use of an identified asset in either of the following situations:

  • if the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or
  • if the relevant decisions about how and for what purpose the asset is used are predetermined and:
  • the customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the lessor has the right to change those operating instructions; or
  • the customer designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

ABC Limited has exclusive use of the leased premises throughout the period of use and is able to obtain all economic benefits of such premises by holding it for the intended purpose to carry out its operations as the company has the right to receive consideration from all the billings from the restaurant.

In the given case, the use of the asset is predetermined i.e. for the purpose of running the restaurant. ABC Limited has the right to operate the identified asset as the entire responsibilities for running the restaurant lies with ABC Limited.

 

All criteria for being in the lease are met, hence the contract contains a lease. Therefore, revenue share to XYZ Ltd shall be treated as lease expenses for the use of the premises.

Conclusion:

Considering the above analysis, ABC Limited is a principal as it is the only party responsible for fulling performance obligations and bearing risks and rewards in relation to the operations of the restaurant.

 

Therefore, ABC Limited shall recognize revenue on a gross basis instead of recognizing it as net of the amount paid to XYZ Ltd and revenue share to XYZ Ltd shall be treated as lease expenses for the use of the premises.


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