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

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.

Accounting Treatment

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.

Finance Lease

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.

Accounting Treatment

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.