What is Lease Payment?

The term “Lease Payment” is analogous to the rental payment. It refers to the payment made, as per the contract agreed, between the lessor and lessee for granting the use of an asset. It may include real estate, equipment, or other fixed assets, for a specific period.

Components of Lease Payment

The lease payment calculation depends on three components:Depreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more fee, finance fee, and sales taxSales TaxThe government levies sales tax on the consumption of various goods and services as the percentage added to the product and services from which the government earns revenue and does the company’s welfare. In the United States, 38 different states have different taxes, from Alaska (1.76%) to Tennessee (9.45%).read more. Now, let us have a look at each of the components separately:

#1 – Depreciation Fee

The depreciation fee is analogous to the principal payment of a loan. It is what the lessee pays the lessorThe LessorA lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period.read more for the loss in value of the asset, which is spread throughout the lease or the time for which the lessee will use the asset. The depreciation fee is expressed as an equal periodic payment, which is derived by dividing the total depreciation by the term of the lease as shown below,

  • Net Capitalized Cost is the addition of the selling price, any additional dealer fees, taxes that are not paid up-front, and outstanding loan balances (if any) minus any down payment and rebates.Residual value is the resale value of the asset at the end of the lease.The lease term is the lease contract’s length (usually in months).

#2 – Finance Fee

The finance fee is analogous to the interest payment on loans, which is what the lessee pays the lessor for using their money. It is to be kept in mind that the finance charges are paid on the total depreciation andResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed.read more residual valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed.read more. The finance fee is mathematically represented as below,

The money factor can be calculated based on the interest rate mentioned in the lease agreement, which is mathematically expressed as shown below,

#3 – Sales Tax

It is the state or local tax charged on the sale price. It is usually paid at the time of signing the lease contract as part of the “due at lease signing” amount. It is mathematically expressed as below,

Lease Payment Formula

The formula for Lease Payment is derived by adding the depreciation fee, finance fee, and sales tax which is mathematically represented as,

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Calculation of Lease Payment with Examples

Let’s see some simple examples of the lease payment to understand it better.

Net Capitalized Cost

The net capitalized cost can be calculated using the below formula,

Net Capitalized Cost = Negotiated Selling Price – Down Payment + Outstanding loan

= $26,000 – $4,000 + $5,000

Net Capitalized Cost = $27,000

Depreciation Fee

Depreciation fee = (Net capitalized cost – Residual value) / Term of lease

= ($27,000 – $16,500) / 36

Depreciation Fee = $291.67

Money Factor

Money Factor = Interest rate / 24

= 6% / 24

Money Factor = 0.0025

Financing Fee

Financing fee = (Net Capitalized Cost + Residual value) * Money factor

= ($27,000 + $16,500) * 0.0025

Financing Fee = $108.75

Sales Tax

Sales tax = (Depreciation fee + Finance fee) * Sales tax rate

= ($291.67 + $108.75) * 5%

Sales Tax  = $20.02

Monthly Lease Payment

Therefore, the Calculation of the monthly lease payment can be done using the below formula,

Monthly lease payment Calculation = Depreciation fee + Finance fee + Sales tax

= $291.67 + $108.75 + $20.02

Monthly Lease Payment  = $420.44

Therefore, John has to pay a monthly lease payment of $420.44.

Advantages

Now, let us have a look at some of the advantages of Lease Payment:

Disadvantages

Now, let us have a look at some of the disadvantages of Lease Payment:

  • In the case of a lease agreement for assets like land, the business is deprived of any appreciation benefit in the asset’s value.The lease expenses shrink a company’s net income without any appreciation in value, which eventually results in limited returns for the equity shareholdersEquity ShareholdersShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders’ Equity Statement on the balance sheet details the change in the value of shareholder’s equity from the beginning to the end of an accounting period.read more.In the case of an operating lease, the lease is not captured as part of a company’sA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more balance sheet. However, most investors deem it to be a long-term debtLong-term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company’s balance sheet as the non-current liability.read more and, as such, adjust the valuation of the business accordingly.In the case of an operating lease, the lessee doesn’t have the option of owning the asset at the end of the leasing period. However, in the case of a financial lease, theA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more is given the option to purchase the asset subject to payment of the residual value.

Conclusion

So, it can be concluded that lease financing is appropriate for businesses that don’t intend to fund their asset purchase through debt or term loan to reduce the burden of CAPEXCAPEXCapex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more. Further, lease payments work best for companies in industries susceptible to technology obsolescence. On the other hand, it is also beneficial for investors who want to invest their money efficiently without participating in the business and earn interest.

This article has been a guide to Lease Payment. Here we look at the calculation of monthly lease payment along with its formula, examples, advantages, and disadvantages.  You can learn more about accounting from the following articles –

  • Top 4 Capital Lease CriteriaFinance vs. LeaseLeveraged LeaseLoan vs. Lease