Meaning Of Accounting For Lease
Often, in various businesses, the owner of the property or asset is not the real owner. Instead, he is only a caretaker of the asset and uses the asset for business purposes. Now, what does caretaker mean? It means that the asset does not belong to him. Rather, he is using another person’s assets to earn a profit. The owner lends his asset to someone for consideration, rent, or another asset. This binds the two in a contract of “lease.”
What Does The Term “Lease” Mean?
The term “lease” refers to contracts in which an owner of an asset or property allows another person to use their asset or property in exchange for some consideration, usually money or other assets. In this contract, the owner of the asset who gives his asset on lease is known as the lessor, and the person who gets the asset on lease is called the lessee.
In this lessor and lessee relationship, the lessor is required to give the lessee all the required permission to use his assets in the best possible manner to earn a profit. On the other hand, the lessee is entitled to the responsibility of taking due care of the asset and not causing any harm to it.
What is lease accounting?
Lease accounting refers to the accounting or treatment of revenue and expenses related to leases. It is the process by which records are maintained and reports are prepared for all the revenue generated and expenses incurred under the lease contract.
A lease accounting system is used to reflect various aspects of a lease, such as:
- Proper recognition and identification of lease liability in the balance sheet of a lessee.
- Recording the value of assets and any change in the value that occurred over some time.
- Recording and recognition of lease liability and the change in liability throughout the year.
- Recognition and identification of income statements including revenue and expenses that occurred from the lease, profit and loss on leased assets, etc.
Types Of Leases
A lease is a legal and vital document that allows a person to use another person’s asset with complete authority and, at the same time, protects the rights of the owner by making the lender accountable for any damage to the asset. There are various types of leases. Some of them are:
It is a lease in which the ownership of the asset is completely transferred to the lessee, and they are responsible for all the risks and rewards arising from the asset. It is a long-term lease agreement and cannot be canceled or called off before the expiry of the contract.
It is a type of lease in which the lessor allows the lessee to use the asset for a particular period. The period for the use of assets in an operating lease is usually less than the asset’s economic life. It is a type of short-term and cancelable lease.
Sale and leaseback
It is a type of lease in which a lessor sold off his asset to the lessee for a long period usually up to the economic life of the asset and then immediately made a lease investment account to get the rental payment for a specific period. This type of lease is most commonly used in the case of real estate matters.
A direct lease is a lease contract in which a lessor purchases new assets from the manufacturer and leasesse them for a long period.
It is a lease agreement between three parties: the lessor, the lessee and the lender. In this, the lessee and lender both contributed to the leased asset, and the proportion of the lessee in the asset is less than the lender. Both of them are responsible for the payment of a principal amount to the lessor.
Domestic and International lease
If the lessor and lessee both belong to the same country, then it is a domestic lease. On the other hand, if any one party, either the lessor or the lessee, belongs to a different country, it is an international lease.
Lessee vs. Lessor Accounting
The counting treatment of a lease contract is different for a lessee and a lessor. A lessor has three ways of treating a lease agreement and showing its possible effect on his financial statement, as opposed to the two ways available to a lessee. The selection of the best possible way among the options available depends on the type of lease, its classification and other aspects.
For a lessor, there are three categories, namely sales-type lease, direct financing lease, or operating lease. The treatment of the lease in each case is as follows:
|Sales Type Lease
|Direct Financing Lease
|In this type of lease, the lessor removes the asset from their balance sheet and adds a new asset: investment in the lease. Over the period, any interest received is shown on the balance sheet. Also, as the payment of assets is received over some time from the lessee, it is deducted from the investment in the lease.
|In this type of lease, the lessor retains the asset and reduces depreciation on the balance sheet every time the value of the asset decreases. Apart from this, any payment received from the lessee is recorded simply on the balance sheet.
|This type of lease lies between the sale type lease and the operating lease. In this, the lessor sold his assets not entirely, as they maintained a depreciation account as well. In this type of lease, the lessor acquires an asset to lease it to the lessee, maintains depreciation on it, and, after some time, gets the asset back with the remaining value.
|Example: this type of lease is used in entertainment businesses such as movie theaters. The lessor gives his assets to independent theater for a long period, say 10–20 years. At the end of the lease, the asset has lost its entire value and is of no use to the lessor. So, it is called a sale-type lease where, in reality, the asset is sold to the lessee, as when the contract is over, the asset will become obsolete and is of no use to the owner.
|Example: office space in a building with various occupants. In this, the lessor is likely to possess the building for his entire life and charge depreciation on it. Also, he will receive income from the rental of office space.
|Example: this type of lease is used in financial institutions where machinery or other assets are acquired and given on lease to earn revenue.
On the other hand, the accounting for the lessee is classified as an operating lease and a finance lease. In each case, the accounting treatment is as follows:
|In the case of a finance lease, the risk and control of assets lie mostly with the lessee. The lessee is responsible for bearing all the risk related to the asset and, at the same time, they are entrusted to use the asset in whatever way they want to gain maximum profit.
|In the case of an operating lease, the lessee is entrusted with the “right to use asset” and accountable for a lease liability on their balance sheet. In this, whenever the lessee makes the payment for the leased asset, they reduce the lease liability from their balance sheet and recognize the expense occurring in the payment of interest.
Lease accounting is a great approach to learning and sharing the revenue and expenditure of assets between the lessor (the owner of the asset) and the lessee (the person who takes the asset on rent). It gives the lessee the right to use assets but, at the same time, holds them accountable for the damage or loss caused to assets. It allows the lessor to make use of his asset and get it back after the contract is over. There are various types of lease agreements that can be formed between two parties depending upon the situation, circumstances, and needs of the lessor and lessee.