A 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. In return, the lessor earns a fixed rent or lumpsum lease payment as agreed upon by the parties in the lease agreement. Leased or rented properties come to the rescue of those who lack the finances to purchase one.
- A lessor is a person or entity who legally owns an asset (real estate, equipment, machinery, etc.) rented to a lessee for a specific period in exchange for rental income.
- The two parties enter into a contract after mutually agreeing to abide by the terms and conditions of the lease.
- Normally, the ownership of an asset given on lease remains with the lessor, while the lessee is only permitted to use the leased property for a certain period.
A lessor is an individual who possesses an asset and leases or rents it for use by another person (lessee) for a certain period. For example, suppose you live in a tourist place and can drive well but don’t own a car. However, you may take a car on lease from a car owner to earn a living by driving it around as a taxi for tourists. In this case, you are the lessee while the car owner is the lessor.
Both lessor and lessee could be an entity too. In return for utilizing the leased asset, the lessee pays a certain compensation. The payments are either made as a lump amount or in installments. The two parties can enter into a leasing agreement by signing a lease which is a legally binding contract.
The lease agreement mentions all the rights and obligations of the lessor and the lessee. They both are obligated to abide by the terms and conditions of the lease. Terms could be that the lessee must make timely payments, not utilize the asset for illegal purposes or bring it any harm.
On the other hand, the property owner must fulfil the duty of disclosure (any material defect in the asset) before handing over the asset. The owner also needs to hand it over during the lease tenure while allowing uninterrupted use. In some cases, the lessee also purchases the property if the contract allows gradual payments.
Lessors of Real Estate
Commercial real estate has been the most common asset leased by the companies and organizations. For example, an individual who doesn’t own a house can find residential real estate on lease at affordable prices. Another example is when telecom companies take lands on lease to place their cell phone towers.
For example, P owns a premise housing a building and ground. L&M college group took this premise on lease for 20 years. The college pays the lease at the beginning of each year. Here, P is the lessor, and the L&M college group is the lessee.
As per federal laws, a landlord has the right to take legal action, i.e., eviction of the tenant, in the following cases:
- Non-payment of rent;
- Not vacating the landlord’s premises even after the lease period is over;
- Any violation of the contractual terms and conditions; and
- Damage or loss caused to the property that affects its value.
Lessors in Other Fields
There are multiple other assets besides real estate that are commonly put on lease to earn a rental income. Some are listed below –
- Advertising space such as hoardings and billboards;
- Other vehicles like a school bus and transport trucks;
- Machinery and equipment like cranes and diagnostic machines, etc.
Malls are a common space for leasing to retailers and top brands. Landlords make handsome returns typically with malls, as these places are often swarming with shoppers. However, widespread lockdowns and the fear of disease swept the earnings of retailers and landlords.
In the wake of the same, retailers at large in the US were reported to be advocating a distinct way of payments to the landlords. Instead of fixed rentals, they prompted landlords to peg the rental payments to the monthly earning of their stores.
Lessor’s Journal Entries
Let us understand the accounting treatment of leasing a piece of equipment from the lessor’s point of view.
#1 – Finance Lease or Capital Lease
Here, the lessee treats an asset like an owner and becomes its owner at the end of the term. Once the tenure end, the lessor will no longer hold the possession of the asset.
This is because capital leases work more like a loan extended to the lessee. Thus, the interest revenues are treated like receiving loan repayment instalments, each time resulting in the deduction of the total lease amount to be received.
Example: Suppose ABC Ltd. leased out crushers to XYZ Corp. under a lease agreement of 5 years, where $ 100000 is payable to ABC Ltd. at the end of every year. The present value of lease payments is $475000, the implicit interest of lease is 10%.
#1 – Entry passed at the start of the lease agreement
#2 – On receiving the first lease paymentLease PaymentLease 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., the lessor makes entries for cash received, reducing the lease receivable like reducing the principal amount of loan.
|Lease Receivable ($100000-10000)||$90000|
|Finance Income ($100000*10%)||$10000|
Also, the net investment in lease decreases with the deduction of the lease receivable, reflecting that at the end of tenure, the property will belong to the lessee.
Net investment in lease = $475000-100000 = $375000
#2 – Operating Lease
Example: Let’s assume that an ABC limited company leases some equipment to XYZ limited for five years as per the terms in the lease agreement. XYZ limited agrees to pay $50,000 at the start of each year.
ABC limited purchased leased equipment at the cost of $400,000, and it has an estimated life of 10 years. ABC limited uses the straight-line depreciation method. On 1/10/95, the asset owner paid the annual insurance premium of $2,000. Again on 15/12/95, the owner paid repair expenses of $1,500 on the asset.
Assuming there is no direct cost initially, the above information is recorded in the following journal entries as the below –
#1 – Collection of Annual Payment on Operating Lease on 1/1/95
It is considered unearned revenue as the company receives rental lease payment at the start of the year, which is treated as a liability. However, once the lessee has used the equipment for an entire year, the lease revenue will be realised at the close of the financial year.
#2 – Payments of Annual Insurance Premium on 1/10/95 (An Executory Cost)
|Repair Expenses (15/12/95)||$1500|
#3 – Recognition of annual depreciation expense:
Depreciation Expenses = 400,000/10 = $40,000
A lessor can retain ownership of the asset while generating rental income from it. Thus, the profit on a lease is at times monumental. Moreover, it generates immediate profit from an asset compared to the long-term, capital-intensive projects.
Such gains can be used for asset development or for meeting other expenses. Also, real estate prices usually appraise during the lease period, adding to the owner’s wealth. Additionally, there are tax deductions or benefits on the lease income.
A lease agreement provides security against any fraudulent practice or damage to the property. In addition, lenders find lessors more reliable for offering loans since they have a fixed source of income and an existing property.
Risks Faced by Lessors
There is always a possibility of earning less than the expected amount. A lessor may bear an opportunity cost risk since the same property may have yielded higher had it been put to other uses rather than leasing. Also, if the value of the leased assets enhances due to inflation or any other reason, the owner fails to benefit from it due to a fixed rental payment.
Further, though secured by the lease agreement, there are chances of damage or wear and tear to the leased asset.
There are also possibilities of depreciation in the value of assets like equipment and machinery given on lease. Moreover, even managing the 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. from the lease is a tedious task due to market volatility.
It takes years for the owner to recover the capital invested in the asset through leasing. Moreover, a lease agreement is usually for a long-term period. During this period, an asset (especially machinery or equipment) can become obsolete due to technological advancement.
A lessor can be defined as a person or company that is the property’s legal owner and provides it on rent to another individual or corporation known as the tenant. The period of occupation is specified in the lease contract, with the tenant paying rental compensation to the landlord for using the asset.
Yes, as normally, only the owner of a property has the right to lease it. However, if you have taken real estate on lease and are willing to sublease it to a third party, you have to take the permission from the property owner before proceeding.
A lessor holds the responsibility of fulfilling all the obligations mentioned in the lease agreement, right from the repairs and maintenance of the property to ensuring other facilities like adequate water supply and ventilation.
Lessee is the tenant who uses property or an asset on rent by paying a monthly or yearly compensation to the landlord.
This article has been a guide to what is the meaning of lessor and its definition. Here we discuss the different types of the lessor as per the accounting perspective and basic and practical examples. You can learn more about accounting from the following articles –