Lessor Meaning Overview Examples Risks Accounting

Lessor Meaning

Key Takeaways

A lessor is a person or entity who legally owns an asset (real estate, equipment, machinery, etc.) rented to a lessee for a specific period in exchange for rental income.The two parties enter into a contract after mutually agreeing to abide by the terms and conditions of the lease.Normally, the ownership of an asset given on lease remains with the lessor, while the lessee is only permitted to use the leased property for a certain period.

Understanding Lessors

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A lessor is an individual who possesses an asset and leases or rents it for use by another person (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) for a certain period. For example, suppose you live in a tourist place and can drive well but don’t own a car. However, you may take a car on lease from a car owner to earn a living by driving it around as a taxi for tourists. In this case, you are the lessee while the car owner is the lessor.

Both lessor and lessee could be an entity too. In return for utilizing the leased asset, the lessee pays a certain compensation. The payments are either made as a lump amount or in installments. The two parties can enter into a leasing agreement by signing a lease which is a legally binding contract.

The lease agreement mentions all the rights and obligations of the lessor and the lessee. They both are obligated to abide by the terms and conditions of the lease. Terms could be that the lessee must make timely payments, not utilize the asset for illegal purposes or bring it any harm.

On the other hand, the property owner must fulfil the duty of disclosure (any material defect in the asset) before handing over the asset. The owner also needs to hand it over during the lease tenure while allowing uninterrupted use. In some cases, the lessee also purchases the property if the contract allows gradual payments.

Examples

Lessors of Real Estate

Commercial real estate has been the most common asset leased by the companies and organizations. For example, an individual who doesn’t own a house can find residential real estate on lease at affordable prices. Another example is when telecom companies take lands on lease to place their cell phone towers.

For example, P owns a premise housing a building and ground. L&M college group took this premise on lease for 20 years. The college pays the lease at the beginning of each year. Here, P is the lessor, and the L&M college group is the lessee.

As per federal laws, a landlord has the right to take legal action, i.e., eviction of the tenant, in the following cases:

Non-payment of rent;Not vacating the landlord’s premises even after the lease period is over;Any violation of the contractual terms and conditions; andDamage or loss caused to the property that affects its value.

Lessors in Other Fields

There are multiple other assets besides real estate that are commonly put on lease to earn a rental income. Some are listed below –

Advertising space such as hoardings and billboards;Cars;Other vehicles like a school bus and transport trucks;Machinery and equipment like cranes and diagnostic machines, etc.

Real-World Example

Malls are a common space for leasing to retailers and top brands. Landlords make handsome returns typically with malls, as these places are often swarming with shoppers. However, widespread lockdowns and the fear of disease swept the earnings of retailers and landlords.

In the wake of the same, retailers at large in the US were reported to be advocating a distinct way of payments to the landlords. Instead of fixed rentals, they prompted landlords to peg the rental payments to the monthly earning of their stores.

Lessor’s Journal Entries

Let us understand the accounting treatment of leasing a piece of equipment from the lessor’s point of view.

#1 – Finance Lease or Capital Lease

Here, the lessee treats an asset like an owner and becomes its owner at the end of the term. Once the tenure end, the lessor will no longer hold the possession of the asset.

This is because capital leasesCapital LeasesA capital lease is a legal agreement of any business equipment or property equivalent or sale of an asset by one party (lesser) to another (lessee). The lesser agrees to transfer the ownership rights to the lessee once the lease period is completed, and it is generally non-cancellable and long-term in nature.read more work more like a loan extended to the lessee. Thus, the interest revenues are treated like receiving loan repayment instalments, each time resulting in the deduction of the total lease amount to be received.

Example: Suppose ABC Ltd. leased out crushers to XYZ Corp. under a lease agreement of 5 years, where $ 100000 is payable to ABC Ltd. at the end of every year. The present value of lease payments is $475000, the implicit interest of lease is 10%.

#1 – Entry passed at the start of the lease agreement

#2 – On receiving the first lease paymentLease PaymentLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more, the lessor makes entries for cash received, reducing the lease receivable like reducing the principal amount of loan.

Also, the net investmentNet InvestmentNet investment is calculated as capital expenditure minus non-cash depreciation and amortization for the period, and it indicates how much the company is investing to maintain the life of its assets and achieve future business growth.read more in lease decreases with the deduction of the lease receivable, reflecting that at the end of tenure, the property will belong to the lessee.

Net investment in lease = $475000-100000 = $375000

#2 – Operating Lease

Under an operating leaseOperating LeaseAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset’s economic rights for a particular period and without transferring any ownership rights at the end of the lease term.read more, the leased property is treated as a source of operating income and is not recorded in the balance sheetBalance SheetA 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. At the end of the tenure, the property will remain with the lessor.

Example: Let’s assume that an ABC limited company leases some equipment to XYZ limited for five years as per the terms in the lease agreement. XYZ limited agrees to pay $50,000 at the start of each year.

ABC limited purchased leased equipment at the cost of $400,000, and it has an estimated life of 10 years. ABC limited uses the straight-line depreciation methodStraight-line Depreciation MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more. On 1/10/95, the asset owner paid the annual insurance premium of $2,000. Again on 15/12/95, the owner paid repair expenses of $1,500 on the asset.

Assuming there is no direct costDirect CostDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.read more initially, the above information is recorded in the following journal entries as the below –

#1 – Collection of Annual Payment on Operating Lease on 1/1/95

It is considered unearned revenue as the company receives rental lease payment at the start of the year, which is treated as a liability. However, once the lessee has used the equipment for an entire year, the lease revenue will be realised at the close of the financial year.

#2 – Payments of Annual Insurance Premium on 1/10/95 (An Executory Cost)

#3 – Recognition of annual depreciation expense:

Depreciation Expenses = 400,000/10 = $40,000

Advantages

A lessor can retain ownership of the asset while generating rental income from it. Thus, the profit on a lease is at times monumental. Moreover, it generates immediate profit from an asset compared to the long-term, capital-intensive projects.

Such gains can be used for asset development or for meeting other expenses. Also, real estate prices usually appraise during the lease period, adding to the owner’s wealth. Additionally, there are tax deductions or benefits on the lease income.

A lease agreement provides security against any fraudulent practice or damage to the property. In addition, lenders find lessors more reliable for offering loans since they have a fixed source of income and an existing property.

Risks Faced by Lessors

There is always a possibility of earning less than the expected amount. A lessor may bear an opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It’s essentially the cost of the next best alternative that has been forgiven.read more risk since the same property may have yielded higher had it been put to other uses rather than leasing. Also, if the value of the leased assets enhances due to inflation or any other reason, the owner fails to benefit from it due to a fixed rental payment.

Further, though secured by the lease agreement, there are chances of damage or wear and tear to the leased asset.

There are also possibilities of 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 in the value of assets like equipment and machinery given on lease. Moreover, even managing the cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more from the lease is a tedious task due to market volatility.

It takes years for the owner to recover the capital investedCapital InvestedInvested Capital is the total money that a firm raises by issuing debt to bond holders and securities to equity shareholders. Invested Capital Formula = Total Debt (Including Capital lease) + Total Equity & Equivalent Equity Investments + Non-Operating Cash read more in the asset through leasing. Moreover, a lease agreement is usually for a long-term period. During this period, an asset (especially machinery or equipment) can become obsolete due to technological advancement.

Lessor Meaning#

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Understanding Lessors#

Examples#

Lessor’s Journal Entries#

#1 – Finance Lease or Capital Lease#

#2 – Operating Lease#

Advantages#

Risks Faced by Lessors#

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