What is a Lease or Leasing?
A famous quote by Donald B. Grant says, “Why own a cow when the milk is so
cheap? All you really need is milk and not the cow.” This quote influences the
concept of Lease. We can compare ‘milk’ with the ‘rights to use an asset’ and
‘cow’ with the ‘asset’ itself. Ultimately, a person who wants to manufacture a
product using machinery can get to use that machinery under a leasing
arrangement without owning it.
A lease can be defined as an arrangement between the lessor (owner of the asset)
and the lessee (user of the asset). Whereby the lessor purchases an asset for the
lessee and allows him to use it in exchange for periodical payments. These
payments are called lease rentals or minimum lease payments (MLP). Leasing is
beneficial to both parties for availing tax benefits or doing tax planning. It is
becoming the most preferred source of asset financing.
At the conclusion of the lease period, the asset goes back to the lessor (the owner)
in the absence of any other provision in the contract regarding compulsory buying
of the asset by the lessee (the user). There are four different things possible post-
termination of the lease agreement.
Also Read: Buy Vs Lease
• The lessee renews the lease perpetually or for a definite period of
time.
• The asset goes back to the lessor.
• The asset comes back to the lessor, and he sells it off to a third party.
• Lessor sells to the lessee.
Purpose of Leasing
The purpose of choosing a lease can be many. Generally, the structure of the lease
is for the following reason:
Benefits of Taxes
The tax benefit is available to both the parties, i.e., Lessor and Lessee. Lessor,
being the asset owner, can claim depreciation as an expense in his books. And
therefore get the tax benefit. On the other hand, the lessee can claim the MLPs,
i.e., lease rentals, as an expense and similarly achieve tax benefit.
Avoid Ownership and thereby Avoiding Risks of Ownership
Ownership is avoided to avoid the investment of money into the asset. It
indirectly keeps the leverage low, and hence opportunities for borrowing money
remain open for the business. A Lease is an off-balance sheet item.
Advantages of Leasing
Balanced Cash Outflow
The biggest advantage of leasing is that cash outflow or payments related to
leasing are spread out over several years, hence saving the burden of one-time
significant cash payments. This helps a business to maintain a steady cash-flow
profile.
Quality Assets
While leasing an asset, the ownership of the asset still lies with the lessor, whereas
the lessee just pays the rental expense. Given this agreement, it becomes plausible
for a business to invest in good quality assets which might look unaffordable or
expensive otherwise.
Also Read: Advantages and Disadvantages of Equipment Leasing
Better Usage of Capital
Given that a company chooses to lease over investing in an asset by purchasing,
it releases capital for the business to fund its other capital needs or to save money
for a better capital investment decision.
Tax Benefit
Leasing expenses or lease payments are considered as operating expenses and
hence, of interest, are tax-deductible.
Off-Balance Sheet Debt
Although lease expenses get the same treatment as interest expenses, the
treatment of lease is different from debt. Leasing is classified as an off-balance
sheet debt and doesn’t appear on the company’s balance sheet.
Better Planning
Lease expenses usually remain constant over the asset’s life or lease tenor or grow
in line with inflation. This helps in planning expenses or cash outflow when
undertaking a budgeting exercise.
Low Capital Expenditure
Leasing is an ideal option for a newly set-up business, given that it means lower
initial cost and lower CapEx requirements.
No-Risk of Obsolescence
For businesses operating in the sector where there is a high risk of technology
becoming obsolete, leasing yields great returns and saves the business from the
risk of investing in a technology that might soon become outdated. For example,
it is ideal for the technology business.
Termination Rights
At the end of the leasing period, the lessee holds the right to buy the property and
has a termination option for the leasing contract, thus providing flexibility to the
business.
Disadvantages of Leasing
Lease Expenses
The treatment of lease payments is as expenses rather than as equity payments
towards an asset.
Limited Financial Benefits
If paying lease payments toward land, the business cannot benefit from any
appreciation in the value of the land. The long-term lease agreement also remains
a burden on the business as the agreement is locked and the expenses for several
years are fixed. In a case when the use of an asset does not serve the requirement
after some years, lease payments become a burden.
Reduced Return for Equity Holders
Given that lease expenses reduce the net income without any appreciation in
value, it means limited returns or reduced returns for an equity shareholder. In
such a case, there is no achievement of the objective of wealth maximization for
shareholders.
Debt
Although a lease doesn’t appear on a company’s balance sheet, investors still
consider long-term leases as debt and adjust their valuation of a business to
include leases.
Limited Access to Other Loans
Given that investors treat long-term leases as debt, it might become difficult for
a business to tap capital markets and raise further loans or other forms of debt
from the market.
Processing and Documentation
Overall, entering into a lease agreement is a complex process and requires
thorough documentation and proper examination of an asset being leased.
No Ownership
At the end of the leasing period, the lessee doesn’t become the asset owner though
quite a good sum of payment is being done over the years towards the asset.
Maintenance of the Asset
The lessee remains responsible for the maintenance and proper operation of the
asset being leased.
Limited Tax Benefit
For a new start-up, the tax expense is likely to be minimal. In these circumstances,
no added tax advantage derives from leasing expenses.