Understanding the accounting of leases for SMEs and mid-sized companies

Whether you’re a small business, mid-size company, if you lease out property, equipment or non-owned assets in exchange for money, you need to account for it. But knowing where to start can be confusing if it’s your first- time accounting leases.

That’s why we’ve compiled everything you need to know about accounting of leases- the kind of leases covered, how to account for them and the laws that govern them. Let’s get right into it.

What are lease accounting standards?

The lease accounting standards 19 (AS19) are regulations set by the Institute of Chartered Accountants of India (ICAI) for the accounting of leases. Companies of all sizes must follow them for all assets leased except lease agreements concerning natural resources, licensing agreements, or land lease agreements.

Under AS 19, finance leases and operating leases need to be accounted for. Let’s take a quick look at their meaning and how to account for them.

Finance Lease

Here, the risk and the rewards earned from the lease is directly transferred from the asset owner i.e. lessor to lessee. In this case, the title may or may not be transferred from the lessor to the lessee.

Operating leases

All leases except finance leases are operating leases.

Now that we know the difference between a finance lease and an operating lease, let’s look at how to disclose and account for them.

Accounting of leases

How should lessees account for finance leases?

1. When the lease agreement is formed, the lessee should recognise the lease as an asset or liability in an amount equivalent to the asset’s market price.
2. They should make an entry in their journals for depreciation.
3. They should distribute lease payments into finance charges to reduce the outstanding liability.
4. They should distribute the finance charge to different periods in the lease term.

How should lessors account for finance leases?

1. They should keep a record of assets in their books at an amount equal to the net investment amount in the lease.
2. They should record the income earned on the lease, reflecting a periodic return date.
3. They should estimate the unguaranteed residual value, which determines the lessor gross investment in lease. Further, in case this value is lesser, they should revise the income allocation for the remaining lease term. Keep in mind that the reduction in value is compared to the amount already recognised without upward adjustment.
4. They should immediately recognise the initial direct cost of the lease in the profit or loss account. Else they should spread this cost over the lease term.

How should lessees account for operating leases?

Lessees should record lease payments as expenses in their profit and loss statements.

How should lessors account for operating leases?

1. They should record assets as fixed assets in the balance sheet.
2. They should account for lease income in their profit and loss statement.
3. They should record any costs incurred, including asset value depreciation, in the profit and loss statement.
4. They should check for impairment and, according to GAAP and provide for it in the account book.

These accounting standards are not applicable to any listed companies and companies with net worth more than Rs.250 Cr, which follow IND AS accounting standards. Applicability of IND AS and its impact will be discussed in separate blog.

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For further loan assistance and information, get in touch with us our leasing experts at Leasing@tatacapital.com and an expert from our side would get back to you.