Updated February 27, 2023
Definition of Lease Payment
Lease payment is the sum paid by the user of the asset (lessee) to the owner of the asset (lessor) for the right to use the asset over a period of time and as per the lease agreement. Lease payment is also called lease rental and is paid for a fixed period of time which is called a lease term.
Explanation
There are so many factors that influence the calculation of lease payment like asset value, depreciation, discount rates, lessee’s credit score, and finance cost. Lease payments are generally done on monthly basis. It is like rent paid to use an asset. A leased asset can be a car, property, computer equipment, software, or any fixed asset.
How to Calculate Lease Payment?
To calculate the lease payment, we need three components, Depreciation, Finance cost, and tax.
Step 1
Depreciation: Depreciation cost is calculated as the total value of the asset minus any residual value divided by the period of the lease. It is the cost for the wear and tear of the asset through its use by the lessee. The total value of the asset is its capitalized value which is the selling price including any taxes, fee if any. So it is calculated as:
(net Capitalized Cost – Residual Value) / Lease Term
Net Capitalized cost: The selling price of the asset including the dealer fee, taxes if any, and excluding the down payment and any outstanding loan balances.
Residual Value: The value of the asset at the end of the lease period.
Lease Term: The time period for which the lease agreement is signed.
Step 2
Finance Cost: These are like the Interest charges the lessee would have to pay on the money used against the loan financing. To calculate the finance cost, we will add the residual value to the net capitalized cost and multiply it by the discount rate/Money factor. It is calculated as:
(Net Capitalized Cost + Residual Value) * Money Factor
Money factor: It is the interest rate decided in the lease agreement. It is usually given per annum, we have to divide by 24 to get the monthly rate.
Step 3
Tax: It is the sales tax charged by the local or state government. It is charged on selling price and is calculated as:
(Depreciation Cost + Interest Cost) * Sales Tax Rate
Formula of Lease Payment
The formula of the lease payment is derived by adding the three components discussed above.
Example of Lease Payment
Lessee Ltd took a machine on lease from Lessor Ltd for a lease term of 60 months. The selling price of the machine is $60,000 with the residual value after 60 months $2,000. The rate of interest applicable is 5%. Lessor ltd also had an outstanding loan on the machine for $5,000. The applicable sales tax rate is 2%. Calculate monthly lease payment.
Here is the calculation of monthly lease payment:
| Amount ($) | |
| Machine Value | 60,000 |
| Residual Value | 2,000 |
| O/s Loan | 5,000 |
| Interest Rate | 5% |
| Sales Tax Rate | 2% |
| Lease Term | 24 (months) |
Depreciation Cost is calculated using the formula given below:
(Net Capitalized Cost – Residual Value) / Lease Term
First, we have to calculate the net capitalized cost,
Net Capitalized Cost is calculated as
Net Capitalized Cost = Machine Value – O/s Loan
- Net Capitalized Cost = 60,000 – 5,000
- Net Capitalized Cost = 55,000
Now , Depreciation Cost is calculated as using the formula given below:
Depreciation Cost = (Net Capitalized Cost – Residual Value) / Lease Term
- Depreciation Cost = (55,000 – 2,000) / 24
- Depreciation Cost = 2,208
Finance Cost is calculated using the formula given below:
(Net Capitalized Cost + Residual Value) * Money Factor
First, we have to calculate Money Factor,
Money Factor = Interest Rate / Lease Term
- Money Factor = 5% /24
- Money Factor = 0.002083333
Finance Cost is calculated as using the formula given below:
Finance Cost = (Net Capitalized Cost + Residual Value) * Money Factor
- Finance Cost = (55,000 + 2,000) * 0.002083333
- Finance Cost = 119
Sales Tax is calculated as
Sales Tax = (Depreciation cost + Finance Cost ) * Tax rate
- Sales Tax = (2,208 + 119) * 2%
- Sales Tax = 47
Monthly Lease payment is calculated as
Monthly Lease payment = Depreciation Cost +Finance Cost + Sales Tax
- Monthly Lease payment = 2,208 + 119 + 47
- Monthly Lease payment = $2,374
Lease Payment in Income Statement
There are two types of lease, Operating Lease and Finance lease. The accounting treatment and recording of lease payment in the Income statement depend upon the type of lease.
Operating Lease: A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership. Lease payment is recognized as an expense in the Income Statement of Lessee in case of operating lease
Finance Lease: A lease that transfers substantially all risks and rewards incidental to its ownership is called a Finance lease.
- The asset is transferred in the books of the lessee at a fair value or present value of minimum lease payments, whichever is less.
- Depreciation is charged by the lessee in its Income statement over the lease term or useful life, whichever is less.
- Lease Rentals constitute principle repayment and Interest, Interest is charged in the Income Statement.
Importance of Lease Payment
- It is important to understand the lease payments in order to correctly record them in the books of the lessor and lessee.
- Lease payment is one of the major factors to decide the type of lease, operating lease, or finance lease. For example:
- A lease is a finance lease where the Present value of Lease Rentals is equal or approximate to the fair value of the asset.
Benefits
Below are some of the benefits of Lease payments:
- Lease payments are mostly done on monthly basis. So, there is no major outflow to cash at one time like in the case of purchasing the machinery. So, it helps to maintain the liquidity of the company.
- The money saved from leasing the asset instead of buying can be utilized in other areas which need investment.
- The risk of an asset becoming obsolete due to a change in technology lies with the owner of the asset.
- Lease payments are shown as expenses in the books of the lessee which reduces its income and further reduces the tax liability.
Disadvantages
Below are some of the disadvantages of Lease payments:
- In case, the value of the leased asset gets appreciated, the user of the asset has no right to such appreciated value.
- In the case of an operating lease, the asset is not shown in the balance sheet of the company and is considered as a long-term debt, which affects its valuation.
- Lease payment being an expense reduces the net income of the company which in turn shrinks the income available for the equity shareholders.
Conclusion
Lease payment is the rent paid by the lessee to the lessor for the use of its asset. It is really advantageous for the companies who have just set up their business to finance the assets through leasing as they divert those funds to other activities than the fixed assets only.
Recommended Articles
This is a guide to Lease Payment. Here we also discuss the definition and how to calculate lease payment? along with benefits and disadvantages. You may also have a look at the following articles to learn more –
