Leasing is an arrangement in which the right to use the asset is transferred to another person by the owner of the asset without transferring the ownership of the asset. Thus, in simple terms, it means giving the asset on hire or rent for use. The person who gives the asset is known as “Lessor” and the person who takes the asset on rent is known as “Lessee”.
- Parties: There are two parties involved in this arrangement, known as LessorLessorA lessor is an individual who legally owns the asset granted on a lease (rented for a long tenure) to the lessee who pays a single lump sum amount or regular payments for using that asset. and 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. .
- Property under Lease: This agreement will specify the property which is being leased by the lessor to the lessee.
- Duration: The right to use a particular property or an asset will be transferred under lease for a particular period. Such a period for which the right is transferred will have to be mentioned in the agreement.
- Lease Rentals: They may be fixed, variable, or a combination of both. Also, the agreement will specify the frequency of the payment of rentals.
Types of Lease
An arrangement may be of following types:
- Financial: It is a kind of arrangement that is not eligible for cancellation, and the rentals are required to be paid until the end of the lease duration. In such type, the duration is generally equal to the useful life of the assetUseful Life Of The AssetUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets..
Thus, the lessor shall show the finance lease as a sale of the asset, and the lessee shall show such leased asset as an asset in his balance sheet, and the present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation. of future rentals shall be shown as a liability.
- Operating: This agreement can be canceled before the expiry of the lease period by providing prior notice. Also, the duration is less than the useful life of the asset. Thus, the lessor is not able to recover the full cost of the asset during the lease period. In such an arrangement, the lessor is liable to bear the maintenance costs too.
- Sale and LeasebackLeasebackLeaseback refers to a financial arrangement whereby the company that has sold the asset can take it back on lease from the buyer. Thus, the sale-leaseback facilitates the former owner to utilize the asset while its ownership lies with the purchaser. : In such an arrangement, an asset is first sold by a company to another party, who then leases it back to the first party. Thus, the company receives consideration against the sale, and also the right to use the asset is retained. This arrangement is entered when the company faces a short-term liquidity crisis.
- Leveraged Leasing: Such an arrangement involves three parties, known as lessor, lessee, and lender. The lessor is financing the asset from the financial assistance of the lender who invests in the asset.
How does it Work?
Leasing allows the lessee to enjoy the right to use an asset without actually owning it. To enjoy such a right to use the asset, the lessee is required to make lease paymentsLease 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. to the lessor. The frequency of such payment can be monthly, quarterly, or yearly depending on the contract. The ownership of the asset remains with the lessor only.
An arrangement ensures the lessee with the right to use an asset without paying the purchase price for the same. For the lessor, the arrangement ensures periodic receipt of lease rentals as against the right to use the asset.
Entering into an arrangement involves negotiation from both the parties. Thus, before a lease agreement is finally signed, terms need to be finalized between the parties. Finalizing a lease is a subjective matter; however, in most cases, it takes 2-3 days.
Lease vs. Rent
|Meaning||Agreement between parties where one party transfers the right to use the asset to another party for the defined time period||Renting is a short-term agreement whereby rent is paid by the party to the owner for the use of any asset such as building, car, etc.|
|Parties||Lessor and Lessee||Landlord and Tenant|
|Maintenance||The responsibility lies on a lessee.||The responsibility lies on the landlord.|
|Duration||Long Term||Short Term|
|Alteration in Contract||Not possible||A landlord can alter the contract.|
|Offer at the expiry of the contract.||Lessee is provided with an opportunity to buy the asset.||No such opportunity is provided in rent|
- A company can enjoy the right to use high-cost assets without investing in them, which otherwise it could not have afforded.
- Lease rentals can be claimed as expenses in the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels., which is a tax-deductible expense.
- The company can manage its cash flowsCash FlowsCash 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. since rentals are spread over the term of the lease contract.
- The funds are saved for other business activities, which otherwise would have blocked in the assets.
- The company is saved from the risk of an asset becoming obsolete as the company is not investing in the said asset.
- An option is available to the company at the end of the lease period to buy the asset.
- Periodic payments are to made, and funds need to be made available for the same.
- Ownership of the asset is not available to the lessee.
- The benefits of capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets. are not available to the lessee.
- The present value of future obligations will be considered as a debt of the company.
An entity should consider various facts such as availability of funds, nature of the asset, a period for which asset is required. Then only a decision can be taken whether leasing will be beneficial or not.
This article has been a guide to Lease and its Meaning. Here we discuss components, types, how does it work along with advantages, disadvantages, and its differences from rent. You can learn more from the following articles –