What is Leasing?
Leasing is a contractual arrangement in which someone (a lessee) pays the owner (or lessor) of a building, land, vehicle, or other asset for the use of that asset. The lease is the agreement between lessee and lessor.
Leasing is very popular for business owners because it is often more cost-friendly to rent buildings, land, new cars, or new vehicles than it is to own them. It is also beneficial to the lessor who owns the building, land, or vehicle because many organizations run their business on leased property, thereby generating profit for the lessor.
In leasing, the lessee can use the property for a specific period of time, and for this the lessor gets a rent amount from the lessee as agreed upon in the leasing contract (lease). Every lease must detail the leasing term (the time period for which the lessee can use the property), when and how to pay rent, the maintenance expenses each party will be responsible for, renewal charges, tax information, etc.
Important Terms in Leasing
- Lessee: A lessee is a person who has the right to use the property of the lessor for a specific period of time by paying a rental amount that is agreed upon in the lease.
- Lessor: A lessor is a person who owns property and gives rights to a lessee to use this property in exchange for rent.
- Lease term: The lease term, also known as the lease period, is the period of time covered by the lease agreement. Generally, the term of the lease is fixed, which means it cannot be cancelled or extended further.
- Fair value: The amount at which the property can be exchanged is known as fair value.
- Useful life: The period at which the property can be used by the lessee.
- Minimum lease payment: The total amount of payment that a lessee will pay to the lessor, excluding taxes, insurance, and maintenance charges.
Content of Lease Agreement
In lease contracts, the contract terms are clearly defined to avoid any future problems. The agreement is signed by both the lessee and lessor agreeing to the terms and conditions of the lease. This agreement should contain the following details:
About the parties: In the lease agreement, name and addresses of both parties should be mentioned clearly. If there is a third party, their information should also be included in the agreement.
About the asset: Details about the asset being rented by the lessee should be mentioned. For instance, the name of the machinery, name of vehicle, condition of vehicle, purchase price of the vehicle, etc. should all be clearly spelled out in the rental agreement.
Period and renewal of lease: The duration for which the asset is being given to the lessee should be stated in the agreement.
Ownership: In a long-term lease, ownership gets transferred to the lessee. But it is not necessary as it depends upon the lessor and lessee in the agreement.
Default in Payment: In case of default by the lessee to pay the down payment within the specified period, the course of action that would be taken by the lessor would be charges, penalties etc.
Surrender of Asset: If the lessor wants to break the lease period, then how much penalty needs to be imposed on the lessee by the lessor must be mentioned specifically.
Condition of Asset: The condition of the equipment that is given to the lessee must be mentioned, like the manufacturing date of the equipment, age of the asset, mileage limit in case of rental vehicle, etc.
Advantages of Leasing
There are various advantages of leasing. Some of them are as follows:
- Less initial investment: When a person decides to start a business, they often need to find a suitable location to establish a shop or office. For this purpose, a lease would be a suitable option, as it requires much less investment than purchasing and owning a property.
- Lower monthly payments: Leasing often involves lower monthly payments. This is again a benefit for the lessee.
- Avoid technological obsolescence: Due to rapid change in technologies, some assets become obsolete very quickly. Therefore, purchasing assets again and again can increase costs for the company. So, it can be beneficial to lease an asset so that the company can easily replace the asset when it becomes outdated.
- Fixed rate financing: Leasing is a onetime arrangement. Hence, any increase in the asset price will not affect the lessee for the term of the lease, as they need to pay only the amount stated in the agreement.
Disadvantages of Leasing
There are also some drawbacks of leasing vs. owning property. For example:
- No ownership rights: In leasing, the lessee only gets the right to use the property but will not have ownership rights of the property. This means the property can be seized back from the lessee in certain circumstances.
- Less access to benefits: The lessee of a property may not be eligible for tax breaks or other benefits offered by the government to property owners. Similarly, a lessee cannot enjoy benefits like depreciation and investment allowance.
- Missing investment opportunity: At times the value of an asset can appreciate, and in such cases it is more advantageous to purchase an asset rather than taking on rent.
- Restrictions on use: The lessee cannot make any changes to the asset because they have no ownership of the asset.
Classification of Lease
Leases can be classified in two categories: operating leases and finance leases.
An operating lease is an agreement between the lessor and lessee where the landlord (lessor) allows the lessee to use the property for a specific period of time. Generally, the time period of the lease is shorter than the lifespan of the asset. In an operating lease, the lessee does not get ownership rights of the property; they only get the right to use the property for a specified period of time as agreed in a leasing contract.
In the book of the lessor: Property is shown as a fixed asset in the balance sheet. Income generated from leasing must be shown in the profit and loss account. On the other hand, depreciation of property is treated as an expense; therefore it is debited from profit and loss account.
In the book of lessee: Rental payments made by lessee are shown as an expense in their profit and loss account.
In a finance lease, the finance company owns the asset for the period of the lease, but all the risk associated with the asset is transferred to the lessee by the lessor, and the lessee also gets the ownership right of the asset for the lease period.
In the books of lessor: The value of investment and the income receivable by the lessor will be treated as a receivable in the balance sheet. Direct expenses are directly debited from the profit and loss account for the year in which expenses incurred or they can be deferred up to the lease period.
In the books of the lessee: Initial direct cost is treated as an asset, therefore it is shown in the balance sheet. The fair value of an asset is considered both an asset and a liability in the case of a finance lease. Liability should be shown separately in the balance sheet.
Rights and Liabilities of Lessor and Lessee
Let us now analyze the rights and liabilities of each party in a lease agreement.
Rights of Lessor:
- The first and foremost right of the lessor is to collect rent from the lessee as per the mentioned terms and conditions in the lease agreement.
- At the end of the lease period, the lessor has the right to get back the asset title transferred to him from the lessee.
Liabilities of Lessor:
- The lessor is liable to disclose any defect in the asset to the lessee. There are two types of defects in the asset, namely latent and apparent defects. An apparent defect is something that can be discovered through inspection, whereas a latent defect cannot be discovered.
- The lessor must give the asset to the lessee as per the terms of the lease agreement.
- The lessor must ensure that they do not interrupt the lessee during the lease period.
Rights of Lessee:
- The lessee has the right to enjoy the benefits of the leased asset during the lease period.
- The lessee has the right to make any payments and have them deducted at the time of rent payment.
- The lessee can also end the lease if there is any damage to the property because of various reasons like fire, flood or any other reasons.
Liabilities of Lessee:
- The lessee is liable to pay rent every month without fail to the lessor or agent.
- The lessee must ensure that they do not make any modifications to the property without the consent of the lessor.
- If the lessee has come to know that anyone has tried to place the lessor or the asset under danger, then the lessee is liable to inform the lessor.
A car lease is a type of auto financing in which a person rents a car from a dealership for a specific time period. Under a car lease, the person or the firm who takes the car on lease has to make monthly payment for the car, and in return, the dealer allows using the car. At the end of the lease period, the asset must be returned back to the dealer.
Common Mistakes and Pitfalls
- Not properly identifying the tenants
- Lack of research about the prevailing rent rates in the market
- Not setting the lease term. There must be mention in the agreement about the start and end date of the leased property
- Not personalizing the agreement
Context and Applications
This topic is significant in the professional exams for both undergraduate and graduate courses, especially for
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