What is Leasing?
Leasing as financial service is a contractual agreement where the owner of equipment or any other property transfers the right to use the equipment or property to the user for an agreed period of time in return for a period payment. The owner of the asset is called lessor and user of such property or asset is known as lessee.
The periodic payment is known and lease rental. At the end of the lease period, the asset or equipment is given back to the lessor unless there is a clear provision for the renewal of the contract in the lease agreement or there is a provision for the transfers of ownership to the lessee. If there is any such provision for transfer of ownership to the user of assets, the deal is treated as hire purchase.
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Therefore, a lease could be generally defined as:
A contract where a party being the owner (lessor) of an asset (leased asset) provides the asset for use by the lessee at a consideration (rentals or down payment ), either fixed or dependent on any variables, for a certain period (lease period), either fixed or flexible, with an understanding that at the end of such period, the asset, subject to the embedded options of the lease, will be either returned to the lessor or disposed off as per the lessor’s instructions
In the contract of lease there are two parties involved, lesser and the lessee. The lessor or lessee can be a company a co-operative society, a partnership firm or an individual involved in the manufacturing, services or allied activities.
The Transfer of Property Act 1882 defines a lease as a transaction in which a party owing an asset provides the asset for use over a certain period of time to another for consideration either in the form of periodic rent and/or in the form of a down payment.
According to Accounting Standard (AS) 19, a lease is an agreement whereby the lessor conveys to the lessee the right to use an asset for an agreed period of time in return for a payment or series of payment.
Essentials Elements of A Lease contract
The essential elements of a lease are as follows:
- Parties: The parties to a lease are the lessor and the lessee. The lessor is also called the owner of the asset and the lessee the user of an asset.
- Subject matter of lease: The subject matter of lease must be immovable property. The word “immovable property” may not be only house, land but also benefits to arise out of land, right to collect fruit of a garden, right to extract coal or minerals, hats, rights of ferries, fisheries or market dues. The contract for right for grazing is not lease. A mining lease is lease and not a sale of minerals.
- Duration of lease: The right to enjoy the property must be transferred for a certain time, express or implied or in perpetuity. The lease should commence either in the present or on some date in future or on the happening of some contingency, which is bound to happen.
Though the lease can commence from a past day, but that is for the purpose of computation of lease period, as the interest of the lessee begins from the date of execution. No interest passes to the lessee before execution. In India, the lease may be in perpetuity.
- Consideration: Like other agreements, consideration is essential in case of lease contract. The consideration for lease is either premium or rent, which is the price paid or promised in consideration of the demise. This premium or rent is known as lease rental.
Advantages of Leasing
Advantages of Leasing are discussed below:
- Cash Saving: By leasing your next equipment acquisition you can save your cash on hand to take advantage of other business opportunities. Also you can have a contingency fund for any emergencies that just come up.
- 100% Financing: With leasing you do not have to make large cash down payment in most cases. Only the first and last month’s payments are required. With leasing you can finance the entire cost of the new equipment including taxes, shipping and equipment setup. With bank financing, you would have to pay for these fees separately most of the time.
- Convenient: The leasing process requires less paperwork than bank financing. Leasing companies usually have lower credit requirements than banks. And the application process takes less time. A lease can be approved in as little as several hours verses weeks or more for some banks. Most leases are approved in 24 to 48 hours.
- Flexibility: Leasing offers flexibility to both the lessor and lessee as both can negotiate the terms and conditions of leasing in such a way as to benefit both the parties.
- No Risk of Obsolescence: Rapid advances in technology can make equipment obsolete quickly. Most leases can be designed so that business can get the latest equipment when needed it and not have to worry about what to do with the old equipment. Also, once approved for equipment leasing, you will not have to go through the application process each time you want to get new equipment.
- Tax Advantages: Leasing payments are 100% tax deductible. If company purchase the equipment, tax benefits will usually not be as much because of depreciation rules.
Disadvantages of leasing
Main disadvantages of leasing are as follows:
- The leasing is efficient only if the equipment or assets can be operated over the whole period of the contract; not using this equipment over the whole period of the contract, mainly due to the lack of production or orders, leads to losses for the beneficiary.
- Lessee cannot enjoy ownership of asset property. At the end of the lease agreement, not only lesser have to return the property in good operating condition as per the terms and conditions of the lease contract.
- Taking a property or equipment on lease can be expensive. Leases are almost always more expensive in the long run than buying items with cash, and leases are sometimes more expensive than obtaining commercial loans to buy the same equipment.
It depends on a number of factors, such as: the cost of funds (interest rate), the length of the lease term, the residual value of the equipment, lease initiation fees and the capitalized cost of the assets or equipment etc.
- Difficulty of property improvements under a lease, the lessee is generally prohibited from making improvements on the leased property without the approval of the lessor. If the property were owned, this difficulty would not arise.
Difference between Leasing and Hire purchase
Essentially, both lease financing and hire purchase are the options of financing the assets. These options vary from each other in many aspects viz. ownership of the asset, depreciation, rental payments, duration, tax impact, repairs and maintenance of the asset and the extent of finance.
These are discussed as follow:
- Ownership of the Asset: In lease, ownership lies with the lessor (owner of asset). The lessee has the right to use the equipment and does not have an option to purchase. Whereas in hire purchase, the hirer has the option to purchase. The hirer becomes the owner of the asset/equipment immediately after the last installment is paid.
- Depreciation: In lease financing, the depreciation is claimed as an expense in the books of lessor. On the other hand, the depreciation claim is allowed to the hirer in case of hire purchase transaction.
- Rental Payments: The lease rentals cover the cost of using an asset. Normally, it is derived with the cost of an asset over the asset life. In case of hire purchase, installment is inclusive of the principal amount and the interest for the time period the asset is utilized.
- Duration: Generally lease agreements are done for longer duration and for bigger assets like land, property etc. Hire Purchase agreements are done mostly for shorter duration and cheaper assets like hiring a car, machinery etc.
- Tax Impact: In lease agreement, the total lease rentals are shown as expenditure by the lessee. In hire purchase, the hirer claims the depreciation of asset as an expense.
- Repairs and Maintenance: Repairs and maintenance of the asset in financial lease is the responsibility of the lessee but in operating lease, it is the responsibility of the lessor. In hire purchase, the responsibility lies with the hirer.
- Extent of Finance: Lease financing can be called the complete financing option in which no down payments are required but in case of hire purchase, the normally 20 to 25 % margin money is required to be paid upfront by the hirer. Therefore, we call it a partial finance like loans etc.