Who is a Lessee?
A lessee is the one who rents the land or property from a lessor. In other words, this lessee is also known as the “tenant” and who holds specific obligations as is defined in the lease agreement and confirmed by the legal system. The lease agreement is a legal binding document for the lessee and the lessor, and if the lessee violates the terms then they could be expelled by law. While the transaction, recordings are made in the books of the lessee. We, in this section, will discuss the same accounting treatment that is being done in the books of the Lessee.
Understanding the Concept
Lessee is the one who rents a property which may be required to follow certain restrictions and guidelines for using this property or the real estate business they are paying to enter and use the property. Suppose the property is a vehicle under a lease, the lessee is required to keep their usage within certain limits. The lessee is subjected to additional fees in the event that the mileage usage of the leased vehicle exceeds the agreed-upon limits in the lease contract.
The leased vehicles are to be maintained by the lessee with regular service and upkeep throughout the term of the agreement. The conditions must be met as the vehicle is to be returned to the auto dealer at the end of the lease. The vehicle would then go on the market as a used car for the proceeds to sale.
Key Points of The Concept
A lessee is a person who rents the land or property, like the vehicle. The person or entity is called the lessee who rents to the lessor.
Generally, Lessees are required to adhere to the guidelines and restrictions while using the property, such as applying mileage limits on a leased vehicle.
A lessee who is a tenant of the commercial or residential property faces different types of limitations and restrictions on their use of the space.
Both the lessees and lessors have respective rights and responsibilities related to the rental property.
Accounting Treatment in the Books of Lessee
When the Royalty is to be paid –
Royalty A/C …. Dr
Short Workings A/C … Dr
To Lessor A/C
(The payment is due in this regard)
For paying the Lessor
Lessor A/C … Dr
To Bank A/C
(Amount Being paid)
For transferring the royalty
Trading/Profit and Loss A/c/ Manufacturing/ Production A/C … Dr
To Royalty A/C
(Amount being recorded in relevant account)
When short workings are recouped
Royalty A/C …. Dr
To Short Workings A/C
To lessor A/C
(Recoupment done)
For irrecoverable short workings
Trading/Profit and Loss A/c/ Manufacturing/ Production A/C … Dr
To Short Working A/C
(Being amount changed to relevant account)
Rights of Lessees
A lessee is the tenant of a commercial or residential property owner who may face quite a different type of restrictions for using their space. A commercial lessee is to be granted by using certain rights to remodel the property for suiting the best to the business which uses the space. This includes repainting of the walls, adding the signboards associated with the company’s brand, or installing new equipment which will be used during the course of business. A commercial lease is to specify the property that is to be returned to its original form when the tenancy terminates.
Residential lessees are limited in the choices for repainting the space they would occupy as tenants. The lessee’s rights include the following:
The right to privacy standards.
The right to basic standards of the habitability such as water supply, electricity, and heat infusion.
The right to live in a space which complies with the local building codes.
FAQs on Accounting for Lessee: Treatment and Entries
1. What is the primary accounting treatment for leases in the books of a lessee under the current accounting standards (Ind AS 116)?
Under Ind AS 116, the primary treatment for a lessee is to recognise most leases on its balance sheet. This means the lessee must record a Right-of-Use (ROU) asset, representing their right to use the leased item, and a corresponding lease liability, representing their obligation to make lease payments. This approach eliminates the old distinction between finance and operating leases for lessees, ensuring greater transparency of a company's lease obligations.
2. How does a lessee initially recognise a lease and calculate the Right-of-Use (ROU) asset and Lease Liability?
At the commencement of a lease, the lessee measures and records two things:
- Lease Liability: This is calculated as the present value of all future lease payments that are not yet paid. The payments are discounted using the interest rate implicit in the lease or, if not determinable, the lessee's incremental borrowing rate.
- Right-of-Use (ROU) Asset: This is initially measured at the same amount as the lease liability, plus any initial direct costs incurred by the lessee, any lease payments made before the commencement date (less any lease incentives received), and an estimate of costs to dismantle or restore the asset.
3. What are the essential journal entries a lessee must pass when a lease commences?
Upon the commencement of a lease, the lessee records the transaction by recognising the asset and the liability on their balance sheet. The fundamental journal entry is:
Right-of-Use Asset A/c Dr.
To Lease Liability A/c
(Being the recognition of the lease asset and liability at the present value of future lease payments)
4. How does a lessee account for lease payments and expenses after the initial recognition?
After the initial recognition, the accounting treatment involves two main processes:
- Depreciation of ROU Asset: The lessee must depreciate the Right-of-Use (ROU) asset over the shorter of the lease term or the useful life of the asset. This is recorded as a depreciation expense in the Profit and Loss Account.
- Interest on Lease Liability: Each lease payment is split between a principal repayment (which reduces the lease liability) and an interest expense. The interest expense is calculated on the outstanding balance of the lease liability and is also charged to the Profit and Loss Account.
5. Why did Ind AS 116 introduce the concept of a Right-of-Use (ROU) asset for lessees?
The primary reason for introducing the Right-of-Use (ROU) asset model was to increase transparency and comparability. Previously, under operating leases, significant lease obligations were kept 'off-balance sheet'. This made it difficult for investors and analysts to get a true picture of a company's assets and liabilities. By requiring lessees to recognise both an asset (the right to use) and a liability (the obligation to pay), Ind AS 116 ensures that the financial statements more faithfully represent the company's financial position and obligations.
6. What is the impact on a lessee's key financial ratios when a lease is capitalised on the balance sheet?
Capitalising leases significantly impacts a lessee's financial statements and ratios. Firstly, it increases the total assets and total liabilities on the balance sheet. This affects key ratios:
- Leverage Ratios: Ratios like the Debt-to-Equity or Debt-to-Asset ratio will increase, making the company appear more leveraged.
- Profitability Ratios: In the early years of a lease, total expense (interest + depreciation) is higher than the straight-line rent expense of an old operating lease, which can lower net profit.
- Performance Ratios: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) increases because lease payments are now classified as interest and depreciation, not operating rent expense.
7. Are there any exceptions where a lessee does not need to recognise a Right-of-Use asset and lease liability?
Yes, Ind AS 116 provides two optional exemptions for lessees, which simplify accounting for certain types of leases. A lessee can choose not to apply the ROU model for:
- Short-term leases: These are leases with a term of 12 months or less from the commencement date and do not contain a purchase option.
- Leases of low-value assets: This applies to leases where the underlying asset itself has a low value when new (e.g., tablets, personal computers, small office furniture), regardless of the lease term.
8. Who are the lessee and the lessor in a lease agreement?
In any lease agreement, there are two main parties:
- The Lessor is the owner of the asset who grants the right to use the asset to another party for a specified period.
- The Lessee is the party who obtains the right to use the asset from the lessor in exchange for making periodic lease payments. The accounting treatment discussed here focuses on the records maintained in the books of the lessee.
