Accounting Treatment in Books of Lessor

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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.

FAQ (Frequently Asked Questions)

1. What is a Trading or Manufacturing Account and a Profit and Loss Account?

Ans. The trading account can be an investment account that consists of securities, cash, or any other holdings. Manufacturing Account is an account that summarizes the manufacturing cost which determines the cost of goods that are manufactured. Trading Account shows the Gross Profit while the Manufacturing Account shows the cost of goods sold which includes the direct expenses. The manufacturing account deals with the raw material and the work-in-progress while the trading account deals with the finished goods only.

The profit and loss, is actually a statement that is the main part of the financial statement which summarizes the revenues, costs, and expenses that is incurred during a specified period, which is usually a fiscal quarter or a year.

2. What Do You Mean by Recoupment of Expenditure?

Ans. The right of Recoupment means the right which is given to the lessee by the lessor to carry-forward or set-off the short-workings from the surplus of the royalties over the Minimum Rent. This can be of two types:

  • Fixed Right of Recoupment: Where the lessor allows the lessee to adjust the short-workings only for a fixed period. 

  • Floating Right of Recoupment: When the lessor allows the lessee to adjust the short-working of any year in the upcoming two or three years.

3. Detail the Term ‘Expenditure’.

Ans. Expenditure is the total purchase price of a good or service. It is an act of spending. For example, a company buying an Rs. 10,00,000 piece of equipment that is estimated to have a useful life of 10 years. This would be classified as an Rs.10 lakh capital expenditure.