Businesses require funding to run their operations. In case a business is unable to generate sufficient funds through its internal operations, it turns to external sources. These funds can be used for day to day business operations or for funding asset purchases. Assets are primarily revenue generating resources. Businesses require different type of assets to run their operations – manufacturing entities primarily require factory building, machines; trading entities may require warehouses; service entities may require office space and office equipment. Whatever the type of business, assets are required to support revenue generation. These assets typically involve high costs and require to be funded by businesses.
Definitions and explanations
A loan is an external source of funding wherein money is borrowed from another entity to fund any purchase or expense. Loans are generally taken from banks or financial institutions but businesses can obtain loans from any willing entity. This may include related parties as well.
Loans can be obtained for a variety of purposes such as funding house purchase, car purchase, personal expenses etc. in the case of an individual and for funding business operations such as purchase of assets, working capital use etc. in the case of businesses.
The entity obtaining the loan is termed as ‘borrower’ and the entity providing the loan is termed as ‘lender’. When loans are obtained, apart from repayment of principal sum borrowed, the borrower is also obligated to compensate the lender by way of monetary compensation termed as ‘interest’. The quantum and charging mechanism of interest is determined by the terms agreed between the borrower and the lender.
The important terms to be determined when obtaining a loan include:
- Loan amount
- Interest rate and mechanism of charging
- Tenure of loan
- Repayment terms – installment basis or lump sum basis
- Collateral/security provided by borrower to lender
The accounting entry in the books will be:
Books of the borrower:
Loan from ABC [Cr]
(Being money received due to loan taken from M/s ABC)
Books of the lender:
Loan to XYZ [Dr]
Bank a/c [Cr.]
(Being money paid for loan given to M/s XYZ)
A lease is a contractual arrangement, whereby one party, the lessee obtains the right to use an asset from another party, the lessor, for a specified period (lease term) in return for periodic monetary payments across the lease term.
Finance lease – the lessee has the right to get ownership of the asset at the end of the lease term, generally on payment of certain residual value
Operational lease – ownership of the asset remains with the lessor and only the right of use vests with the lessee. Akin to a rent arrangement
Several type of assets can be obtained on lease – from land and building to machinery required in manufacturing operations to vehicles.
Difference between loan and lease:
The key points of difference between loan and lease have been listed below:
- A loan involves borrowing of funds, by one entity from another entity for the purpose of funding any expense or purchase.
- A lease is an arrangement involving transfer of right to use an asset by one entity to another, in exchange of regular lease payments.
- In case of a loan, the entity providing the funds is called the lender and entity obtaining the funds is called the borrower.
- In case of a lease, the entity providing the asset is called the lessor and the entity using the asset is called the lessee.
3. Benefit received by the borrower/lessee
- In case of a loan, the borrower obtains funds i.e.: actual money.
- In case of a lease, the lessee obtains right to use an asset.
4. Compensation received by the lender/lessor
- In case of a loan, the lender receives compensation for providing funds in the form of interest.
- In case of a lease, the lessor receives compensation for transferring right to use the asset, in the form of monetary lease payments.
5. Certainty of compensation received by the lender/lessor
- In case of a loan, the quantum of interest received may or may not be certain depending on whether it is a fixed rate or a floating rate loan.
- In case of lease arrangement, the quantum of lease payment received by the lessor is certain and predetermined.
6. To fund
- Depending on the type of loan taken, it can be used to fund any type of expenses.
- In the case of lease, it is an arrangement only useful for obtaining assets.
- Loans are generally provided by banks or other financial institutions.
- Lease are generally provided by asset leasing companies.
- Loans can be repaid on lump sum or installment basis, depending on the terms of the loan agreement.
- Leases are taken only on installment basis.
- Availing loans generally require the borrower to provide an asset as security or collateral, as guarantee for repayment of loan, to the lender.
- There is no concept of providing security in case of a lease arrangement, other than the leased asset itself.
10. Documentation and formalities
- Availing a loan requires extensive documentation and formalities specially to establish credit-worthiness of the borrower.
- Availing an asset on lease is a simpler process as it just requires ascertainment of lessee’s need for the asset and ability to make lease payments.
- In the case of a loan, a liability (debt) is created in the books of the borrower and an asset (receivable) is created in the books of the lender.
- In the case of a lease (operational), no asset or liability is created, only lease expense and income are recorded. In the case of a financial lease, an asset may be created in the books of the lessee depending on the jurisdictional accounting rules.
Conclusion – loan vs lease:
A loan and a lease are both modes of aiding operations for a business. In the case of assets, whether a business should avail a loan to purchase or whether it should obtain the asset on lease is guided by several business factors. Value of the asset, financial strength of the business, term for which asset is to be used, ability to provide collateral and repay are some of the important guiding factors.