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 of 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 companies across the globe. 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.
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, which is financed by the raising of Debt. Effectively in a Finance Lease, the balance sheet gets equally impacted by the addition of 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 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 effectively no purchase of Equipment takes place. As such, no asset or liability is reported on the balance sheet by the business. Lessee simply makes payment of 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 StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities., the lease payment for this lease is reported as an outflow from Operating Activities. Since Operating Lease doesn’t impact the Balance Sheet of Lessee, Operating Lease is also referred to as Off-Balance Sheet Financing 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 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 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 payments, 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, which reduces the risk arising out of Obsolescence of Equipment on account of change in Technology 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 business is able to deduct Depreciation and Interest expense for tax purpose and can consider lease as a rental agreement for financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. 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 is 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 make a decision pertaining to the type of lease after taking into consideration its business model, Asset life, and the changes in the sector to 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 calculation along with advantages and disadvantages. You can learn more about accounting from the following articles –