Lease payments refer to the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor being the owner of such asset and asset is generally taken back by the owner after the expiration of lease term.
What is Lease Payment?
The term “Lease Payment” is analogous to the rental payment. It refers to the payment made, as per the contract agreed, between the lessor and lessee for granting use of an asset. It may include real estate, equipment, or other fixed assets, for a specific period.
Components of Lease Payment
The calculation of lease payment is dependent on three components, which are depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. fee, finance fee, and sales taxSales TaxThe government levies sales tax on the consumption of various goods and services as the percentage added to the product and services from which the government earns revenue and does the company's welfare. In the United States, 38 different states have different taxes, from Alaska (1.76%) to Tennessee (9.45%).. Now, let us have a look at each of the components separately:
#1 – Depreciation Fee
The depreciation fee is analogous to the principal payment of a loan. It is what the lessee pays the lessorThe LessorA lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period. for the loss in value of the asset, which is spread throughout lease or the time for which the lessee will use the asset. The depreciation fee is expressed as equal periodic payment which is derived by dividing the total depreciation by the term of the lease as shown below,
- Net Capitalized Cost is the addition of the selling price, any additional dealer fees, taxes that are not paid up-front, and outstanding loan balances (if any) minus any down payment and rebates.
- Residual value is the resale value of the asset at the end of the lease.
- Term of lease is the length of the lease contract (usually in months).
#2 – Finance Fee
The finance fee is analogous to the interest payment on loans, and it is what the lessee pays the lessor for using their money. It is to be kept in mind that the finance charges are paid on the total of depreciation and residual valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed.. The finance fee is mathematically represented as below,
The money factor can be calculated based on the interest rate mentioned in the lease agreement which is mathematically expressed as shown below,
#3 – Sales Tax
It is the state or local tax charged on the sale price. It is usually paid at the time of signing the lease contract as part of the “due at lease signing” amount. It is mathematically expressed as below,
Lease Payment Formula
The formula for Lease Payment is derived by adding the depreciation fee, finance fee and sales tax which is mathematically represented as,
Calculation of Lease Payment with Examples
Let’s see some simple examples of the lease payment to understand it better.
Let us take the example of John, who is planning to buy a car on lease. The lease will be for a period of 36 months and charged an annual interest rate of 6%. John managed to negotiate the selling price to be $26,000 with a down payment of $4,000 and an outstanding loan balance of $5,000. The car is expected to have a residual value of $16,500 at the end of 36 months from now. The applicable sales tax rate is 5%. Determine the monthly lease payment for John.
Net Capitalized Cost
The net capitalized cost can be calculated using the below formula as,
Net Capitalized Cost = Negotiated Selling Price – Down Payment + Outstanding loan
= $26,000 – $4,000 + $5,000
Net Capitalized Cost = $27,000
Depreciation fee = (Net capitalized cost – Residual value) / Term of lease
= ($27,000 – $16,500) / 36
Depreciation Fee = $291.67
Money Factor = Interest rate / 24
= 6% / 24
Money Factor = 0.0025
Financing fee = (Net Capitalized Cost + Residual value) * Money factor
= ($27,000 + $16,500) * 0.0025
Financing Fee = $108.75
Sales tax = (Depreciation fee + Finance fee) * Sales tax rate
= ($291.67 + $108.75) * 5%
Sales Tax = $20.02
Monthly Lease Payment
Therefore, Calculation of Monthly lease payment can be done using below formula as,
Monthly lease payment Calculation = Depreciation fee + Finance fee + Sales tax
= $291.67 + $108.75 + $20.02
Monthly Lease Payment = $420.44
Therefore, John has to pay a monthly lease payment of $420.44.
Now, let us have a look at some of the advantages of Lease Payment:
- The cash outflow or the lease payments are spread across the term of the lease agreement, which eliminates the burden of one-time substantial cash pay-out. It immensely helps the liquidity positionLiquidity PositionLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. of a business and eases the pressure on the cash flow profile.
- By choosing leasing over-investment in an asset, a company releases the capital, which can be used to fund other business needs.
- In an operating leaseAn Operating 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., the lease is treated differently from debt as it is classified as an off-balance sheet liability and, as such, doesn’t appear in the balance sheet. However, the financial lease doesn’t offer this advantage.
- Leasing can be a viable option for businesses operating in industries that are vulnerable to the risk of technology obsolescence. By leasing, a company safeguards itself from the risk of investing in a technology that is likely to become obsolete.
Now, let us have a look at some of the disadvantages of Lease Payment:
- In the case of a lease agreement for assets like land, the business is deprived of any appreciation benefit in the asset’s value.
- The lease expenses shrink the net income of a company without any appreciation in value, which eventually results in limited returns for the equity shareholdersEquity ShareholdersShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period..
- In case of an operating lease, the lease is not captured as part of the balance sheet of a company. However, most investors deem it to be a long-term debtLong-term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability. and, as such, adjust the valuation of the business accordingly.
- In case of an operating lease, the lessee doesn’t have the option of owning the asset at the end of the leasing period despite. However, in case of a financial lease, the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. is given the option to purchase the asset subject to payment of the residual value.
So, it can be concluded that lease financing is appropriate for business that doesn’t intend to fund their asset purchase through debt or term loan to reduce the burden of CAPEXCAPEXCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.. Further, the lease payments work best for companies in industries that are susceptible to technology obsolescence. On the other hand, it is also beneficial for investors who want to invest their money efficiently without participating in the business and earn interest.
This article has been a guide to Lease Payment. Here we look at the calculation of monthly lease payment along with its formula, examples, advantages, and disadvantages. You can learn more about accounting from following articles –