Accounting of Lease Transactions in the Books of Lessor and Lessee

Meaning of Lease: A lease is a contract that outlines the terms under which one party agrees to rent an asset. The leased asset could include real estate, vehicles, equipment, or other types of property. The lessor is the person who owns the asset and provides the right to use it to a third party, known as the lessee. The lessee is the party who uses the asset and agrees to compensate the owner for its use by paying royalties.

Lease Accounting: Lease accounting refers to the set of rules and guidelines used to record and report lease transactions in financial statements. It includes identifying, measuring, presenting, and disclosing leases in accordance with accounting standards such as IFRS, GAAP, or Ind AS 116 (which governs lease accounting in India).

Royalty: Royalty is the consideration paid for the use of specific rights over both tangible and intangible assets. Unlike rent, which applies only to tangible assets, royalty payments are made based on output or sales rather than fixed periods. Royalty agreements typically include a minimum payment clause, whereas rent does not have such a provision.

Short-Workings: Short-workings refer to the amount by which the minimum rent exceeds the actual royalty paid. These are recorded in the books of both the lessee and the lessor. The lessee can recoup short-workings by adjusting them against excess royalties in future years. This process is called the recoupment of short-workings or redeemable dead rent. Short-workings are also referred to as ‘royalty suspense’ by the lessor.

Recoupment of Short-Workings: Recoupment of short-workings is the process of adjusting short-workings by offsetting them against future excess royalties. The royalty agreement includes a recoupment clause that gives the lessee the right to recoup short-workings within a specified period.

Types of Recoupment:

1. Fixed Right of Recoupment: The lessee is allowed to adjust short-workings for a fixed period.
2. Floating Right of Recoupment: The lessee is allowed to adjust short-workings at any time within a specified period.

Accounting Treatment of Royalties:

1. In the Books of the Lessee:
   • Royalties based on output are debited to the Trading or Manufacturing Account as they are considered normal business expenses.
   • Royalties based on sales are debited to the Profit & Loss Account.
2. In the Books of the Lessor:
   • Royalty received is credited to the Trading or Manufacturing Account if it is considered regular business income.
   • Royalty received based on sales is credited to the Profit & Loss Account.

Journal Entries for Royalty Transactions:

Important Notes:

• Journal entries assume a clause on Minimum Rent and Recoupment of short-workings.
• Royalties based on output should be debited to the Manufacturing or Production Account, whereas royalties based on sales should be treated as selling expenses and debited to the Trading or Profit & Loss Account.

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