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Financial Accounting - Leasing
In the field of real estate, leasing is a popular term because it is advantageous to own land and building. Today, most of the businesses run their offices on the leased premises.
A Lease is an agreement under which lessee (the person/entity, who takes possession of the property) get the right to use the premises for the agreed period of time in lieu of the rent as agreed between both Lessor (owner) and lessee. Lessor has an ownership right of assets, but still lessee has an unrestricted right to use that asset.
Every lease contract should cover the following terms −
Period of lease.
Timing of the payment to be made along with the amount of rent.
About maintenance expenses, taxes, insurance, provision for renewal of lease agreement.
The Accounting Standard 19, issued by the Council of the Institute of Chartered Accountants of India, covers the disclosure of appropriate accounting policies in the financial statements.
Standards 19 are mandatory in nature and applicable to all lease agreements except some given below −
- Lands to be used under the lease agreement.
- For use of natural resources like oil, gas, timber, metal, etc.
- Video recording, films, motion picture, patents, and copyrights.
Important Terms in Leasing
Following important terms are commonly used in lease accounting −
Lessee − Lessee is a person who possess the right to use the asset in lieu of agreed rent for a certain period of time (as per the lease agreement).
Lessor − Lessor is the owner who gives right to the lessee to use his asset/property in lieu of rent for a certain period of time.
Lease Term − Usually, lease agreement is contracted for a fixed and non-cancellable period called as lease term. It is also known as ‘Lease Period.’ Lease term may be further extended as agreed with or without further amendment/s.
Fair Value − Fair value is an amount on which an asset can be exchanged or it may be the value of liability settled.
Useful Life − It can be
A period over which an asset could be used by the lessee.
Expected number of units that can be produced by that asset.
Inception of Lease − It is the date on which principal provision of the lease are committed to.
Residual Value − An estimated fair value of an asset at the end of the lease term is called as residual value.
Minimum Lease Payment − Total payment to be made by lessee to lessor during the lease terms excluding taxes, insurance, maintenance charges, contingent rent, etc.
Contingent Rent − It is based on a factor other than passage of time, lease payments i.e. percentage of sale, etc.
Unguaranteed Residual Value − An expected fair value at the end of the lease period is called as Unguaranteed Residual Value.
Popularity of Leasing
One of the main reasons behind the popularity of leasing is its simplicity to both the parties i.e. lessor as well as lessee. It is beneficial in terms of its documentation and also provides tax advantage. Selection and purchase of asset come under the purview of leasing company, and use and rent payment of the assets are the part of lessee.
Since lessor remains owner of the assets, so he can claim for the depreciation in his books. Interestingly, he can enjoy the tax benefit against the depreciation. Similarly, lessee pays the rent and records such rent in his books as expenses for the purpose of tax benefit.
Advantages of Leasing
Main advantage of leasing is given hereunder −
Lessee can use the asset without actually purchasing it, means full finance without any margin money.
It provides flexibility in fixation of the rent and the lease period as per the requirements.
In the Balance sheet of a lessee, leased assets are not shown as asset or liability of the company, hence the credit capacity of the lessee remains un-affected.
Leasing provides an opportunity to lessee to earn additional profit and to improve earnings per share.
Deduction of a rent is eligible to claim tax benefit (as business expenditure).
Without heavy investment, lease rent can be paid out from the income generated by the use of the assets.
Tax benefit of the depreciation may be claimed by lessor according to the Income Tax Act.
Taking advantage of the full utilization of the asset is possible under a lease agreement; chances of ignorance are high, where company purchases asset as its own.
In case of a closely held company, it provides better wealth planning solutions.
It provides protection to lessee against the inflation.
Strict provisions of the financial institutions for acquiring an asset can be avoided through a lease agreement.
Disadvantages of Leasing
Some of the disadvantages of leasing are −
Leasing is not very much useful for some of the new businesses, as earning through the business comes much after the investment.
Some of the incentives as provided by the state and the central government, cannot be enjoyed due to lease agreement.
The assets, whose values are likely to appreciate, should be purchased instead of leasing.
In case of variation clause in a lease agreement, rental structure can be changed due to change in the rate of interest, rate of depreciation, etc.
Classification of Lease
According to AS-19, following are the two categories of Leasing −
- Operating lease
- Finance Lease
Operating lease is an agreement wherein the lessor (owner) allows the renter (lessee) to use the agreed asset for a particular period. Usually, the lease period is shorter than the economic life of the asset. Further, lessor does not actually transfer the ownership rights. The Lessor gives the right to the lessee to use the asset in return of regular payments for an agreed period of time.
As per AS-19, following are the accounting treatment in the books of lessor and lessee −
In the books of Lessor −
Assets should be treated as the fixed assets in the Balance sheet of a lessor.
Rental income should be treated as an income in the Profit and Loss account.
Depreciation should be treated as expenses and should be debited from the Profit & Loss account.
An initial cost can be deferred to the lease period of the asset or may be booked as expenses in the year, in which actually incurred.
Depreciation will be charged as per AS-6.
In the books of Lessee −
Lessee should treat a rental payment as expenses in the profit and loss account.
In case where lease is able to secure for lessor the recovery of his capital outlays plus a reasonable return on the fund invested during the lease period is called financing lease. Finance lease in non-cancellable contract and also, lessor is not responsible for any expenses and taxes of the leased asset.
In the books of Lessor −
Total value of the investment plus income receivable on it will be treated as receivables in the Balance sheet.
Direct expenses may be directly debited from the profit and Loss account in the year of expenses incurred or may be deferred up to the lease period.
In the books of Lessee −
Initial direct cost will be treated as an asset.
Fair value of the leased assets should be considered as an asset and a liability in the finance lease.
It is an appropriate to show liability separately in the Balance sheet.
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