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"A lease is a legal contract under which one party agrees to pay rent for property owned by the other party."…

"A lease is a legal contract under which one party agrees to pay rent for property owned by the other party." Discuss.

Solution

A lease is a contractual arrangement between a lessor, the owner of the property, and a lessee, the user of the property. It gives the lessee the right to use a specific asset for an agreed period in return for periodic cash payments (lease rent). The statement is true, because the lessee pays rent for an asset legally owned by the lessor, while the lessor keeps ownership and earns income from it. The statement can be discussed under the following points:

  1. Legal contract between two parties: a lease is a binding agreement that sets out the asset, the lease term, the rent, the payment dates, and the rights and duties of the lessor and lessee.
  2. Ownership stays with the lessor: the lessor remains the legal owner, while the lessee only gets the right to use the asset. For example, a company may rent office space in Kathmandu from a building owner.
  3. Periodic rent payments: the lessee pays rent in instalments instead of paying the full price of the asset at once.
  4. Popular way of financing: leasing needs only a small initial cash outlay and has flexible terms, so it conserves the lessee’s cash. Leasing is big business worldwide, financing roughly one-third of all capital equipment acquired each year.
  5. Operating lease: the lessee gets the right to use the asset for a limited period and does not record it as an asset or the payments as a liability. The rent is treated as rent expense by the lessee and as revenue by the lessor. Examples include renting an apartment or hiring a car. This is called off-balance-sheet financing, because the lease does not increase the company’s debt.
  6. Capital (finance) lease: the lease transfers substantially all the risks and benefits of ownership to the lessee. It is treated like a purchase: the lessee records a lease asset and a lease obligation and charges depreciation on the asset.
  7. Conditions for a capital lease: a lease is a capital lease if any one of these conditions is met:
    • ownership is transferred to the lessee during the lease term;
    • there is a bargain purchase option, allowing the lessee to buy the asset well below its fair market value;
    • the lease term is 75% or more of the asset’s economic life;
    • the present value of the lease payments is 90% or more of the asset’s fair market value.
  8. Accounting for a capital lease: the asset and the obligation are recorded at the present value of the minimum lease payments. Each payment is split into interest expense and a reduction of the lease obligation, and depreciation is charged on the lease asset.
  9. Balance sheet presentation:
    • the lease asset, less accumulated depreciation, is shown under property, plant and equipment;
    • the portion of the obligation due next year is a current liability;
    • the rest of the obligation is a long-term liability.
  10. Exception to the statement: the statement describes an operating lease perfectly. Under a capital lease, however, the lessee is treated in the accounts as the economic owner, even though legal title may still be with the lessor.

A lease is a legal rental contract that lets a business use an asset without buying it. Its accounting treatment depends on whether it is an operating lease or a capital lease.

Explore more questions

  1. 1.

    (a) What is accounting information? Who are the users of accounting information? Explain.

    (b) Define source of documents. Write down the objectives of source of documents.

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  2. 2.

    The Balance Sheet and Income Statement of a company have been given below:

    Liabilities Year I Year II Assets Year I Year II
    Equity share capital 800,000 1,000,000 Land and building 300,000 340,000
    Share premium 80,000 100,000 Plant and machinery 500,000 700,000
    Bank loan - 200,000 Inventories 230,000 300,000
    Accounts payable 180,000 160,000 Accounts receivable 220,000 250,000
    Provision for taxation 50,000 60,000 Provision for doubtful debts (40,000) (30,000)
    Profit and loss 140,000 280,000 Cash at bank 40,000 240,000
    Total 1,250,000 1,800,000 Total 1,250,000 1,800,000
    Particulars Rs. Rs.
    Sales 1,000,000
    Less: Cost of goods sold 600,000
    Gross profit 400,000
    Less: Operating expenses 100,000
    Interest on bank loan 20,000
    Depreciation on machinery 40,000
    Provision for taxation 60,000
    Loss on sale of machine (Book value Rs. 60,000) 40,000 260,000
    Net income 140,000

    Required: Cash flow statement by using direct method

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  3. 3.

    Following are the transaction of a company.

    I. Started business with cash Rs. 800,000 in exchange of 8,000 shares of Rs. 100 each.

    II. Deposited into bank Rs.300,000.

    III. Took a bank loan of Rs. 100,000 @ 10% interest.

    IV. Sold merchandise goods for Rs.300,000 on account.

    V. Purchased merchandise goods for Rs.180,000 on account

    VI. Paid Rs.10,000 for insurance premium.

    VII. Received Rs.270,000 after deduction of 10% discount from the customers

    VIII. Paid Rs. 170,000 in full settlement of Rs.180,000 by cheque.

    IX. Paid electricity bill Rs. 5,000

    X. Pre-paid office rent Rs.26,000 by issuing cheque.

    Additional Information

    a) Closing stock Rs. 20,000.

    b) Prepaid rent expired Rs. 24,000.

    c) Outstanding interest Rs.10,000

    Required:

    a. Journal entries for above transactions

    b. Accounts receivable and payable account

    c. Triple column cash book

    d. Adjusted Trial balance

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  4. 4.

    What is value added statement? Explain in brief the advantages of value added statement.

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  5. 5.

    (a) On Ashad 2081, Bank Statement disclosed a balance of Rs.16,000 and Cash Book showed the balance of Rs.14,800

    i) Deposit in transit Rs. 1,900

    ii) Outstanding cheques Rs. 1,000.

    iii) Notes receivable and interest collected by the bank Rs.4,000 and Rs. 200 respectively.

    iv) Cheque of Rs. 7,450 deposited by the company was recorded by the bank as Rs.7,350

    v) A customer's cheque for Rs.1,500 was returned by the bank due to insufficient fund.

    vi) A cheque for Rs. 7,800 paid by the bank was recorded as Rs. 7,600 by the company.

    vii) Bank charge Rs.300 for the service provided by the bank.

    Required: Bank Reconciliation Statement

    (b) Write down the meaning of bad debts. Also explain in brief the methods of estimating bad debts.

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  6. 6.

    Following transactions are related to machinery:

    Shrawan 1, 2078: A machinery was purchased for Rs. 400,000.

    Chaitra 30, 2078: Second machinery was purchased for Rs. 200,000.

    Poush 30, 2080: First machinery became obsolete and sold for Rs. 300,000.

    Depreciation charged @ 15% p.a. on original cost method.

    Required: Machinery account for three years ending 31st Chaitra, 2080.

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