What is the Equipment Lease?
Equipment Lease refers to the lease where one party who is the owner of the equipment allows another party to use the equipment in exchange for the periodic rentals where the ownership during the tenure of the agreement remains with the lessor only and has the right to cancel the lease right away when he finds that the lessee has contravened any terms of the lease agreement.
In simple words, it is a contractual agreement between two parties, namely the Lessor ( owner of the asset) and Lessee (user of the asset), wherein the Lessor allows the Lessee to use the asset for a specified period in return for periodic payments popularly known as Lease payments.
The equipment lease agreement is a popular model that is frequently used by The The equipment lease agreement is a popular model that companies across the globe frequently use. However, this Lease has its benefits and disadvantages, which we will try to understand through this article. Instead of buying the assets, companies prefer to leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.” them, thereby saving millions of dollars in the purchase. However, this Lease has its benefits and disadvantages which we will try to understand through this article.
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Types of Equipment Leases
This Lease is mostly divided into two types which are as follows:
Type #1 – Finance Lease
Finance Lease is known as Capital LeaseCapital LeaseA capital lease is a legal agreement of any business equipment or property equivalent or sale of an asset by one party (lesser) to another (lessee). The lesser agrees to transfer the ownership rights to the lessee once the lease period is completed, and it is generally non-cancellable and long-term in nature. in the United States and is the purchase of Equipment by the business, financed by raising Debt. Effectively in a Finance LeaseFinance LeaseFinance lease simply refers to a method of providing finance in which the leasing company purchases the asset on behalf of the user and rents it to him for a set period of time. The leasing company is referred to as the lessor, and the user is referred to as the lessee., the balance sheet gets equally impacted by adding an equal amount to both Assets and Liabilities of the Balance Sheet of the Company.
Over the term of the Finance Lease, the Lessee will recognize depreciation expense on the equipment and interest expenses on the debt liability. Interest ExpenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense. is equal to the lease liability at the beginning of the period multiplied by the Lease Interest RateInterest RateThe lease rate is the interest rate associated with leasing the asset during the lease period. In simple terms, it is the compensating amount that otherwise the lender would have earned if the same property, equipment, or vehicle would have been up for some other use..
Type #2 – Operating Lease
Operating LeaseOperating LeaseAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset's economic rights for a particular period and without transferring any ownership rights at the end of the lease term. is a rental agreement between the Lessor and Lessee where no equipment purchase occurs. The lessee pays periodic lease payments, which are recognized as rental expenses in the Income StatementThe Income StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements..
In the Cash flow StatementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business., the lease payment for this lease is reported as an outflow from Operating Activities. Since Operating Lease doesn’t impact the Balance Sheet of the Lessee, Operating Lease is also referred to as Off-Balance Sheet FinancingOff-Balance Sheet FinancingOff-balance sheet financing is a company’s practice of excluding certain liabilities and, in some cases, assets from getting reported in the balance sheet in order to keep the ratios such as the debt-equity ratios low to ease financing at a lower rate of interest and also to avoid the violation of covenants between the lender and the borrower. Assets.
Calculation Example of Equipment Lease Payments
Click International leases a Machine from Harry International for its internal use purpose. The Details are furnished below:
- Monthly Lease Payment: $10,000
- Useful Life (in Years): 4
- lease Rate: 6%
At the end of the four years, the machine will be returned to Harry International, who will sell the machine for its Scrap Value.
Based on the above facts, let’s try to calculate the Lease paymentsCalculate The Lease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration. and other depreciation details:
Click International will classify the Lease as a Finance Lease instead of an Operating Lease because the asset is being leased for 75% or more of its useful life. Also, it is mentioned clearly that at the end of the lease, the asset will be disposed of for its scrap value.
Thus at the beginning of the Lease, the Present Value of the Lease, i.e., $34651, will be recorded under the Asset side and liability side of the Balance Sheet of Click International.
Therefore, the Schedule of Lease Payments will be:
Refer to the Excel Template for detailed calculation.
- It is a less costly source of financing as it requires no initial down paymentsDown PaymentsDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. , which result in conserving cash for the user of the asset, i.e., Lessee.
- Operating Lease allows the Lessee to return the asset at the end of the lease, reducing the risk arising out of Obsolescence of Equipment on account of technological changes, etc.
- Another advantage that usually arises in the case of the Operating Lease type of Equipment Lease is that it doesn’t result in a Balance Sheet Liability as it is an Off-Balance Sheet Financing. Hence Leverage ratiosLeverage RatiosDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity. such as Debt/Equity ratioDebt/Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. etc. are lower compared to the outright purchase of Assets.
- Certain Tax advantages are accorded to firms operating in the United States whereby such lease is treated as an Ownership position just like the purchase of Assets, and the business can deduct Depreciation and Interest expense for tax purposes. It can consider a lease as a rental agreement for financial reportingFinancial ReportingFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making. purpose.
- Equipment lease agreement, when considered as a Finance Lease, results in Leverage Ratios such as Debt to Assets RatioDebt To Assets RatioDebt to asset ratio is the ratio of the total debt of a company to the total assets of the company; this ratio represents the ability of a company to have the debt and also raise additional debt if necessary for the operations of the company. A company which has a total debt of $20 million out of $100 million total asset, has a ratio of 0.2, Debt to Equity Ratio to be higher on account of reporting of Liability on the Balance Sheet.
- Operating Income is reduced when a Lease is considered as an Operating Lease as the whole lease payment is considered as a Rental Outflow and debited from the Income Statement.
- Usually, in Equipment Lease, particularly in Operating Lease, the tenure and the amount of Lease Payment are fixed at the beginning of the Lease itself, irrespective of whether the Equipment becomes obsolete due to the technological changes, etc., which can result in a committed costA Committed CostCommitted Costs are fixed, budgeted, or confirmed payments to be made in the future to vendors for goods or services to be taken, which are necessary for the smooth flow of the business and whose absence may disrupt the main operations of the business, potentially having a significant impact on the company. for the Lessee without resulting in any benefit.
- An Operating Lease results in fixed cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. payment in the form of Lease Rentals and can be burdensome for business when sales are impacted due to adverse business conditions.
Essential Points About Change in Equipment Lease
Under the Equipment lease agreement, the classification of Lease (Operating or Financing Lease) is determined by the economic substance of the lease transaction, which means that if the lease agreement results in the transfer of all rights and risks related to ownership to the Lessee, then such lease will be characterized as Finance Lease and will be shown on the Balance Sheet of Lessee as discussed above. These criteria apply both under US GAAP and IFRS.
Equipment Leasehold’s important implication on the business and its choice has widespread consequences. The business should decide on the type of lease after considering its business model, Asset life, and the changes in the sector in which such asset is put to use to make the most out of this lease.
This article has been a guide to Equipment Lease and its meaning. Here we discuss the types of Equipment Lease, its examples, and calculations along with advantages and disadvantages. You can learn more about accounting from the following articles –