Prepaid Lease Agreements: Definition, Requirement, Advantages, Disadvantages

Definition:

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

The prepaid lease agreement is considered to be one of the most popular leasing options used by organizations.

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

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

In order for prepaid leases to be applicable and made possible, there are a couple of factors that need to 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 remaining life of the asset.
  • The residual value at the end of the lease term is supposed to be at least 20% of the original value of the asset 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 that is offered is a reasonable amount.
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Advantages of Prepaid Lease Agreements

Prepaid Lease can be beneficial for companies because of a number of reasons. Firstly, it can be seen that the seller is able to recover around 80-90% of the value of the asset. 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 to maintain their business results.

On grounds of taxation, it can be seen that 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 the fact 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, regardless of the fact that 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 a risk of assets being seized by lenders in the case where the lessor goes bankrupt.

In the case where 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.

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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.

Regardless of the fact that it does require some upfront payment, yet it still is an option that keeps the liquidity of the company in check. It can be considered as a tax-efficient method that is structured to deal with assets that have a considerably longer life.

It differs from other lease options in the sense that it requires some technical considerations to be fulfilled in order for a prepaid lease to be applicable.

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

Prepaid Lease Agreements can be considered as an extremely vital tool that can benefit both parties because of a number of ways. However, given the contingencies and technicalities involved, it can be seen that there are numerous repercussions including added costs.

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