What is a Lease?
A lease is a type of agreement where a person has a right to use an asset for quite a certain period of time from another person who is the owner of the asset in return for a definite payment. So, the owner here is the Lessor. While, the user is the Lessee and the amount paid by the lessee for acquiring the lessor’s asset is termed as royalty, which he pays to the lessor.
Accounting Treatment in Books of Lessor
Royalty is the sum that is payable by the lessee to the lessor for the use of his rights vested in the lessor. Royalty is a type of periodic payment, which is generally paid on grounds of sale or output. Example: Royalty is paid for extraction of mines from the minefield, for use of patents, for using the technical know-how, also to an author for the sale of his books.
The accounting treatment used here is - Royalty received by the lessor is credited to Trading or Manufacturing Account as it is considered as regular business income in the books of the lessor. While, the royalty that is received on the basis of sales is credited to the Profit and Loss Account.
Again, minimum rent is the amount that is paid by the lessee to the lessor irrespective of any benefit derived from the asset. Thus, this rent payable is known as Dead Rent or Rock Rent.
The Landlord also may allow the lessee the right to recoupment of short-workings. Here, the lessor will receive only the minimal rent until the period of recoupment.
Royalty Meaning in Accounting
Royalty is the periodical payment by the user of the asset to the actual owner or the creator of the same asset for its use in his tenure. The owner or the author of the asset like mine, patent, book, artistic work, and others may allow the third party like the licensee, publisher, etc to use its own creation in return for a consideration, and that is meant by royalty.
The royalty payment is made by the user to the owner. While, the consideration that is paid in lieu of using the asset of the owner is determined in terms of the number of items that are produced or sold.
Parties in Royalties Accounting
The parties who are engaged in this royalty are the lessor and a lessee, we will discuss both of their role in detail now -
1. Lessor
Lessor as mentioned already, is the person who creates or owns the asset, in particular, he also provides the right of using the asset to the third party who is known as the lessor or the landlord. Further to detail, the lessor receives consideration from the third party for using the rights to use his own asset. Examples included in lessons are the owner of the mine or a quarry, an author of a book, could be an artist in the case of music composition.
2. Lessee
Next about Lessee, Lessee is an important person here, who initiates the contract. He is the person who uses the asset and thus makes a contract to repay the owner of the asset with royalty. He pays a royalty to the creator or the owner in lieu of consideration for using such an asset. Examples of Lessees can be publishers, miners, etc.
Accounting Treatment of Royalties
The accounting treatment for royalty which will be in the books of the lessee will be royalty paid on the basis of output is debited to Trading or Manufacturing Account as it is considered as normal business expenditure. Whereas, the royalty which is paid on the basis of sales, is debited to the Profit & Loss A/c.
FAQs on Accounting for Lessor Transactions
1. What is a lease transaction from the perspective of a lessor?
From a lessor's perspective, a lease is a contractual agreement where the lessor, who is the legal owner of an asset, grants the right to use that asset to another party, the lessee, for a specified period. In return, the lessor receives periodic payments. The lessor retains ownership of the asset, and the accounting treatment depends on whether the lease transfers substantially all the risks and rewards of ownership to the lessee.
2. What are the two main types of leases a lessor must account for as per accounting standards?
A lessor must classify leases into two main types based on the transfer of risks and rewards associated with the asset's ownership. These are:
- Finance Lease: A lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee. The lessor derecognises the asset and recognises a lease receivable.
- Operating Lease: Any lease other than a finance lease. Here, the lessor retains the risks and rewards of ownership, keeps the asset on their balance sheet, and recognises lease income over the lease term.
3. How does a lessor account for an operating lease in their books?
In an operating lease, the lessor continues to recognise the leased asset on their Balance Sheet. The lease payments received from the lessee are recognised as income in the Profit and Loss Account on a straight-line basis over the lease term. The lessor also continues to charge depreciation on the leased asset as per their normal depreciation policy.
4. What is the accounting treatment for a finance lease in the books of the lessor?
For a finance lease, the lessor treats the transaction as if they have sold the asset on credit. The lessor derecognises the physical asset from their books and recognises a receivable at an amount equal to the net investment in the lease. The lease payments received are split into two parts: a reduction of the principal receivable and finance income, which is recognised in the Profit and Loss Account.
5. Why is the distinction between a finance lease and an operating lease so crucial for a lessor's financial statements?
The distinction is crucial because it fundamentally changes how assets, income, and receivables are reported. An operating lease shows the lessor owning more physical assets (on the Balance Sheet) and earning steady rental income. A finance lease, however, removes the physical asset and replaces it with a financial asset (lease receivable), generating finance income. This impacts key financial ratios like Return on Assets (ROA) and asset turnover, providing a very different picture of the lessor's business model and financial health.
6. What are the key conditions that help a lessor classify a lease as a finance lease?
As per Indian Accounting Standards (Ind AS) 116, a lease is generally classified as a finance lease if one or more of the following conditions are met:
- The lease transfers ownership of the asset to the lessee by the end of the lease term.
- The lessee has an option to purchase the asset at a price expected to be sufficiently lower than the fair value at the date the option becomes exercisable.
- The lease term is for the major part of the economic life of the asset.
- The present value of the lease payments amounts to at least substantially all of the fair value of the leased asset.
- The leased asset is of a specialised nature such that only the lessee can use it without major modifications.
7. How does a lessor's Balance Sheet differ when accounting for a finance lease versus an operating lease?
The impact on a lessor's Balance Sheet is significant. For an operating lease, the asset remains under 'Property, Plant, and Equipment' on the asset side. For a finance lease, the asset is removed and replaced with a 'Lease Receivable' under financial assets. This changes the composition of the lessor's assets from fixed/non-current assets to financial/current & non-current assets, reflecting a shift from renting out equipment to providing financing.
8. In a royalty agreement, what is the significance of 'Minimum Rent' for the lessor?
In a royalty agreement (a specific type of lease), Minimum Rent (or Dead Rent) is a crucial safety net for the lessor. It guarantees the lessor a minimum fixed income from the asset, regardless of whether the lessee generates any output or sales (e.g., from a mine or book sales). This protects the lessor from receiving little to no income during periods of low production or sales by the lessee, ensuring a consistent return on their asset.
