Lease: Definition, Features, Advantages ,Disadvantages & Types.
A lease is a contract wherein the owner (lessor) of an asset (leased asset) grants the lessee access to the asset for a consideration (rent), which may be fixed or based on variables, for a time period (lease period), which may be fixed or flexible, with the understanding that, subject to the embedded options of the lease, the asset will either be returned to the lessor or disposed of in accordance with the lessor’s instructions at the end of such period.
Simply put, leasing is a way to pay for the use of an asset over a predetermined period of time. Although the idea of renting seems very similar to it, they are very different.
Members of a Lease/Parties to a Lease
A lease has two parties: The owner, known as the lessor, and the user, known as the lessee. The person who owns the asset and leases it is known as the lessor. The lessee leases the asset and uses it for the duration of the lease. Leasing does not require ownership. Technically, to be a lessor, one does not need to own the asset; rather, one must have the right to use the asset. Thus, unless the parent lessor has restricted the right to sub-lease, a lessee can be a lessor for a sub-lessee.
Features of Lease
The following are the main characteristics or components of the leasing:
- The Parties to the Contract :The Owner and the User are the main parties to a lease financing contract.
- Assets: The lease financing contract’s subject matter is the property that will be leased.
- Lease Period: The fundamental lease term during which the lease cannot be terminated.
- Rental Payments: The lessee pays to the lessor for the lease transaction is the lease rental.
- Maintain: Provision for the payment of the costs of maintenance and repair, taxes, insurance, and other expenses appertaining to the asset leased.
- Lease Term: The length of time that the lease agreement is in force is known as the lease term.
- Ownership: The lessor retains ownership of the assets during the lease period, and the lessee is permitted to use them.
- Termination: The contract may be terminated at the end of the period.
- Renew or Purchase: At the end of the basic period, you have the option of renewing the lease or purchasing the assets.
- Default: The lessee may be held liable for all future payments at once, in exchange for title to the asset.
Advantages/Benefits of Lease Financing
The Advantages/benefits from the lessee’s perspective
- Capital Savings: By providing 100% financing, leasing pays the entire cost of the equipment used by the business. Since there is no down payment, the lessee is not required to provide or pay any margin money. In this way, the capital or financial resources that are conserved can be applied to other productive endeavors, such as the acquisition of inventories.
- Flexibility and Convenience: The lease agreement can be customized to meet the needs and preferences of all lessees with regard to the lease period and lease rentals.
- Cash flow planning : Cash flow planning is made possible by leasing, which gives the lessee the ability to do so. The money the business receives from using the same assets can be used to pay the rent.
- Liquidity Position Improvement: Through the use of the sale and leaseback strategy, leasing allows the lessee to strengthen its liquidity position.
- Obsolescence Risk Shifting: By renting assets rather than purchasing them outright, the lessee can place the burden of obsolescence risk on the lessor.
- Maintenance and Specialized Services: In the case of a unique type of lease agreement, the lessee may utilize the Lessor’s Specialized Services for the upkeep of the leased asset. Although the lessor charges higher rentals for these services, leases experience lower overall administrative and service costs as a result of the lessor’s specialized services.
- Off-the-Balance-Sheet Financing: Since the lease is not recorded as an asset or a liability, it offers the lessee “off-balance-sheet” financing.
The advantages/Benefits from the viewpoint of the lessor
Leasing capital assets has a number of lauded benefits, including:
- Higher profits: The Lessor can get higher profits by leasing the asset.
- Tax Benefits: The Lessor being the owner of an asset, can claim various tax benefits such as depreciation.
- Quick Returns: Leasing the asset allows the lessor to receive returns more quickly than investing in longer-term projects.
Disadvantages / Drawbacks of the lease.
Disadvantages /drawbacks of lease financing from the perspective of the lessee
- Higher Cost: The lease rental is regarded as a form of financing at a higher cost because it includes a margin for the lessor as well as the cost of obsolescence risk.
- Risk: Risk of losing access to assets in the event that the leasing company fails.
- No Alteration in Asset: Lessee cannot make changes in assets as per his requirement.
- Penalties for Lease Termination: If the lessee must end the lease before the agreed-upon term has run out, he must pay penalties.
Disadvantages /Drawbacks from a lesser perspective
- High Risk of Obsolescence: Due to the quick pace of technological change, the Lessor must deal with the risk of obsolescence.
- Price Level Changes: When there is inflation, an asset’s price increases, but the lease rentals stay the same.
- Long-term Investment: It takes a long time for leasing to recoup the cost of an asset because it requires a long-term investment in its purchase.
Types of the Lease
Leasing takes different types, which are given below;
Based on Nature.
- Operating lease.
- Financial lease.
Based on the Method of Lease.
- Direct lease.
- Sale & Leaseback.
- Leverage lease.
Based on Nature
- Operating Lease: An operating lease is a cancelable contractual agreement whereby the lessee agrees to make periodic payments to the lessor, often for 5 or fewer years, to obtain an asset set’s services. According to the International Accounting Standards (IAS-17), an operating lease is one that is not a finance lease.
- Financial Lease: A financial (or capital) lease is a longer-term lease than an operating lease that is non-cancelable and obligates the lessee to make payments for the use of an asset over a predetermined .period of time. According to the International Accounting Standard (IAS-17), in a financial lease, the lessor transfer to the lessee substantially all the risks and rewards identical to the ownerships of the asset whether or not the title is eventually transferred.
Based on the Method of Lease.
- Direct Lease: Under direct leasing, a firm acquires the right to use an asset from the manufacture directly. The ownership of the asset leased out remains with the manufacture itself.
- Sale & Leaseback: Under the sale & leaseback arrangement, the firm sells an asset that it owns and then leases to the same asset back from the buyer. This way, the lessee gets the assets for use, and at the same time, it gets cash.
- Leveraged Lease: Leveraged lease is the same as the direct lease, except that a third party, the lender, is involved in addition to the lessee & lessor. The lender partly finances the purchase of the asset to be leased; the lessor turns to be a borrower.
So, based on the discussion above, we can conclude that a lease is a contract in which one party, the lessor (owner) of an asset, agrees to grant use of that asset to another, the lessee, in exchange for periodic rental payments. Rent is a deductible expense for tax purposes.