What is Lessor vs. Lessee?
The difference between a Lessor vs. a Lessee is that the lessor lends an asset, such as equipment or property, to the lessee, in exchange for periodic interest payments throughout the borrowing term.
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Lessor vs. Lessee – Differences in Roles
There are two parties involved in a lease agreement: 1) the lessor and 2) the lessee.
- Lessor → The party with ownership of the asset that lends the asset to the lessee, or borrower, for a specified period of time.
- Lessee → The party that borrows an asset with the promise to pay interest to the lessor and return the asset at the end of the contract.
The lease is a contractual, legally-binding agreement between the two parties, where the lessor lends an asset for use by the borrower, or lessee.
In exchange for the right to use the asset, the lessee must be periodic interest payments to the lessor throughout the borrowing term.
Once the maturity date per the lease agreement arrives, the lessee must return the borrowed asset to the lessor, or else there will likely be legal ramifications. If applicable to the situation, the lessor can expect to receive compensation for any material losses related to damages to the asset.
Lessor vs. Lessee in Lease Agreement
Limited Rights of the Lessee
The decision to lease an asset rather than purchase it outright can be more reasonable in terms of capital allocation, i.e. it is usually cheaper to lease than to purchase.
The assets involved in lease agreements are most often real estate properties, equipment, and machinery.
The usage of the borrowed asset is restricted, however, as any material changes such as customization must be approved by the lessor. And suppose the borrowed asset is sold; the sale must receive authorization from the lessor before the transaction can be completed (and the proceeds are distributed to the lessor, with the exact split dependent on the contract terms).
The option for the lessee to purchase the asset will often also be offered at maturity.
Types of Lease Agreements
Capital Lease vs. Operating Lease Accounting Treatment (GAAP)
There are several types of lease agreements frequently seen in corporate finance, namely the following two structures:
- Capital Lease → A capital lease, or “finance lease”, describes a lease agreement where the lessee obtains ownership of the asset. Since the lessee possesses full control over the asset (and is responsible for any maintenance or associated ongoing costs), the accounting standards under GAAP require the lease agreement to be recorded on the lessee’s balance sheet as an asset with a corresponding liability, with interest expense recognized on the income statement.
- Operating Lease → An operating lease, on the other hand, is a lease agreement where the lessor continues to retain full ownership of the asset (and all associated considerations). The lessor remains responsible for any related costs of the asset, such as maintenance, rather than the lessee. Contrary to the accounting treatment of a capital lease agreement, the asset is not recorded on the balance sheet of the lessee.
Sale and Leaseback
Another common type of lease arrangement is called a “sale and leaseback”, which is a specific type of agreement whereby a buyer purchases an asset from another party with the intent to lease it right back to the seller. The seller, in effect, becomes the lessee whereas the buyer becomes the lessor.