Equipment Lease

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.”read more 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.

Equipment Lease

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Types of Equipment Leases

This Lease is mostly divided into two types which are as follows:

Types of equipment lease

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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.read more 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.read more.

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.read more 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.read more.

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.read more, 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.read more 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.

Equipment Lease Example 1-1

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.

Example 1-2

Therefore, the Schedule of Lease Payments will be:

Example 1-3

Refer to the Excel Template for detailed calculation.

You can download this Equipment Lease Excel Template here – Equipment Lease Excel Template

Advantages

Disadvantages

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.

Conclusion

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.

Recommended Articles

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 –

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