Accounting Treatment in the Books of Lessee

In a royalty agreement, the lessee (tenant) pays the lessor (landlord) for the use of land, property, or other resources. The lessee records journal entries for royalty payments, minimum rent (also known as dead rent), short workings, and recoupment of short workings in their books of accounts. These transactions are reflected in both the Journal Entries and Ledger Accounts.

Key Components in Lessee’s Books:

• Lease Liability

In the lessee’s books, lease liability refers to the present value of future lease payments the lessee is obligated to make under the lease contract. This liability is recorded at the inception of the lease and reflects the financial obligation over the lease term. It includes fixed payments, variable payments based on an index or rate, and amounts expected under residual guarantees. Lease liability is subsequently measured by reducing it through lease payments and increasing it by the accretion of interest expense.

• Right-of-Use (ROU) Asset

The right-of-use (ROU) asset represents the lessee’s right to control and use the leased asset for the lease term. This asset is initially measured at the amount of the lease liability, adjusted for initial direct costs, lease incentives, or advance payments. Over time, the ROU asset is depreciated systematically, typically on a straight-line basis, over the shorter of the lease term or the asset’s useful life. The ROU asset ensures the lessee properly reflects the economic benefit derived from the leased asset.

• Lease Payments

Lease payments in the lessee’s books refer to the regular periodic payments made to the lessor, covering the use of the leased asset. These payments usually include both principal and interest components. The principal portion reduces the lease liability, while the interest portion is charged as an expense to the profit and loss account. The schedule of lease payments is crucial for managing cash flow and ensuring compliance with contractual obligations over the entire lease term.

• Interest Expense

Interest expense arises from the unwinding of the discount on the lease liability over time. As lease liabilities are measured on a present value basis, each lease payment reduces the liability and incurs an interest cost. The interest expense is recognized in the profit and loss account and gradually decreases over the lease term as the liability reduces. This accounting treatment ensures the lessee’s financial statements reflect the time value of money related to future lease obligations.

• Depreciation Expense

Depreciation expense refers to the systematic allocation of the cost of the right-of-use (ROU) asset over the lease term. In the lessee’s books, depreciation is charged to the profit and loss account, usually on a straight-line basis, unless another method better reflects the asset’s consumption pattern. The depreciation period is typically the lease term, or the useful life of the underlying asset if ownership transfers. This expense ensures the gradual write-down of the asset’s value over time.

• Initial Direct Costs

Initial direct costs are the incremental costs directly attributable to negotiating and securing the lease agreement, such as legal fees or commissions. In the lessee’s books, these costs are included as part of the ROU asset’s initial measurement. Instead of expensing these costs immediately, they are capitalized and amortized over the lease term through the depreciation of the ROU asset. Proper treatment of initial direct costs ensures accurate representation of the total cost of obtaining the lease.

• Lease Modifications

Lease modifications involve changes to the lease terms, such as extending the lease, changing payment amounts, or modifying the asset’s scope. In the lessee’s books, lease modifications may require remeasurement of both the lease liability and the ROU asset, depending on whether they create a separate lease or adjust the existing agreement. Accounting standards provide specific guidance on recognizing and adjusting for modifications, ensuring that financial records remain accurate and reflect current contractual terms.

• Disclosures in Financial Statements

Lessee’s books must include detailed disclosures about leases in the financial statements, such as the nature of the leases, total lease liabilities, maturity analysis, lease expenses, and any significant assumptions or judgments used. These disclosures provide transparency to stakeholders, helping them understand the impact of leasing activities on the company’s financial position and performance. Proper disclosure ensures compliance with accounting standards like IFRS 16 or ASC 842 and improves the reliability of reported financial information.

Example Scenario:

Consider a situation where:

• Minimum Rent (Dead Rent) = ₹100,000
• Actual Royalty (based on production) = ₹80,000 in Year 1, ₹120,000 in Year 2
• Short Workings in Year 1 = ₹20,000 (₹100,000 – ₹80,000)
• Recoupment of Short Workings in Year 2 = ₹20,000

Journal Entries in the Books of Lessee:

Ledger Accounts in the Books of Lessee:

1. Royalty Account

2. Minimum Rent Account

3. Short Workings Account

4. Lessor’s Account

5. Short Workings Recouped Account

6. Bank Account

Explanation of Journal Entries:

1. Year 1 Entries

• • The first entry records the royalty amount based on actual production.
  • The second entry records the minimum rent payable to the lessor.
  • The short workings are recorded when the actual royalty is less than the minimum rent.
  • Finally, the payment to the lessor is recorded by crediting the bank account.

2. Year 2 Entries

• • The actual royalty exceeds the minimum rent, so no short workings are created.
  • The short workings from Year 1 are recouped by reducing the royalty payment in Year 2.

Explanation of Ledger Accounts:

• Royalty Account reflects the actual royalty amounts based on production.
• Minimum Rent Account shows the minimum rent payable each year.
• Short Workings Account records the shortfall between minimum rent and actual royalty.
• Lessor’s Account tracks payments made to the lessor and any amounts owed.
• Short Workings Recouped Account tracks the amount of short workings recovered in subsequent years.
• Bank Account reflects the cash payments made to the lessor.