What are Prepaid Lease Agreements? Definition, Requirement, Advantages, Disadvantages

Definition:

In the modern-day age, it can be seen that lease agreements are used more than ever. In this regard, a couple of options are available to parties involved, which can be chosen per personal preference.

The prepaid lease agreement is one of the organizations’ most popular leasing options.

Prepaid Lease can be termed as a technique that structures fixed assets in a non-conventional manner. The structure involves prepaying a lease that uses assets over a considerable time.

Prepaid Lease Agreements have a payment structure that constitutes the lessee leasing the asset for a considerably longer timeline.

There is a pre-payment of the lease amount. At the end of the lease agreement, the lessor also has the option to buy the respective asset.

Requirements for a Prepaid Lease

For prepaid leases to be applicable and made possible, some factors must be included in the stated analysis.

  • The stated asset is not supposed to have significant life left. The lease term of the asset in case of prepaid lease agreements is not supposed to be greater than 80% of the asset’s remaining life.
  • The residual value at the end of the lease term is supposed to be at least 20% of the asset’s original value when purchased. The residual value in this case can be referred to as the amount for which the asset can be sold in the market after the lease period has ended.
  • The lessee can be extended with an option to purchase the asset, given that the amount offered is reasonable.

Advantages of Prepaid Lease Agreements

Prepaid Lease can be beneficial for companies because of several reasons. Firstly, it can be seen that the seller can recover around 80-90% of the asset’s value.

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This means that the assets that have a long life can be maximized.

In the same manner, it can be seen that prepaid lease agreements result in considerable tax savings for the lessor.

Therefore, prepaid lease agreements can be of considerable value in helping businesses maintain their results.

On grounds of taxation, it can be seen that a prepaid lease also gives the option to adjust the tax liability to the advantage of the lessor, such that it helps them to get a tax saving of around 50-60%.

Disadvantages of Prepaid Lease Agreement

The greatest consideration of prepaid lease agreements is that it does not allow the lessee to recognize the asset on the balance sheet.

This is up to the point where the lease term ends, and the lessee ends up buying the asset.

Therefore, even though the lessee had already made an upfront payment, he cannot declare it as an asset unless the end of the term.

Secondly, the lessee would be unable to get the desired tax benefits via depreciation.

Therefore, it is supposed to be declared as an expense on the Income Statement. Lastly, the lessee is also exposed to the risk of lenders seizing assets when the lessor goes bankrupt.

If the lessor becomes bankrupt, the lenders will have a right to take possession of the asset, regardless of the contract agreement between the lessor and the lessee.

Conclusion

Therefore, it can be seen that prepaid lease agreements give the option to the lessee to use the asset, without having to pay a lump sum amount.

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Even though it requires some upfront payment, it still is an option that keeps the company’s liquidity in check. It can be considered a tax-efficient method to deal with assets with considerably longer life.

It differs from other lease options because it requires some technical considerations for a prepaid lease to be applicable.

For an asset with a long-term economic useful life, it can be seen that it can eventually result in considerable cost savings in tax liability reductions of around 50-60%.

Prepaid Lease Agreements can be considered an extremely vital tool that can benefit both parties in several ways.

However, given the contingencies and technicalities involved, it can be seen that there are numerous repercussions including added costs.