When looking for options to finance our small businesses, we frequently come across the terms finance lease or operating lease. In this post, we’ll discover how finance lease works, compare finance lease vs operating lease and determine which is the better option for our business.
What is a Finance Lease?
A finance lease, also known as a capital lease or sales lease, is a sort of commercial lease in which the legal owner of an asset is a finance firm, and the user rents the asset for an agreed-upon period of time. The leasing firm, usually a finance company, is referred to as the lessor in this legal contract, while the person who uses the asset is referred to as the lessee.
When a lessee signs this agreement, they gain operational control of the asset. They accept full responsibility for all risks and rewards involved with asset ownership. The lease provides the lessee with the economic characteristics of asset ownership for accounting purposes. The item will be recorded as a fixed asset in the lessee’s general ledger. In this case, the lessee will report the lease payment’s interest as an expense.
The rental contract must meet at least one of the following characteristics to be categorised as a finance lease under US GAAP:
- The present value of the lease rentals is equal to or greater than the asset’s fair market value.
- The lease period exceeds 75% of the useful life of the leased asset.
- The lessee is given the opportunity to purchase the leased asset at a lower price than the fair value of the leased item.
- At the end of the lease, the lessor relinquishes legal ownership of the leased asset to the lessee.
A lease is categorised like a finance lease in an IFRS jurisdiction if all of the following fundamental requirements are met:
- The lessor retains legal ownership of the asset throughout the lease period.
- The lessee bears the risk and rewards associated with leased assets.
- After the lease expires, legal ownership of the leased asset passes from the lessor to the lessee.
Primary Characteristics of Finance Lease
- When contract hire is not an option, this is a popular option for business and commercial customers.
- Allows your firm to manage your vehicles and have the assets appear on your balance sheet.
- You can choose to pay the entire cost of the vehicle, including any interest costs, on a monthly basis, or you can pay it all at once.
- Pay reduced monthly installments with a final payment dependent on the vehicle’s market value at the end.
- At the end of the contract, the vehicle is either sold to a third party or scrapped.
- Pay the remaining balloon payment and continue to run the vehicle under a peppercorn arrangement.
How a Finance Lease Works
A finance lease is essentially a business rental agreement that includes the following steps:
Step 1:
The lessee chooses an asset that they need for their business.
Step 2:
The lessor, who is usually a finance company, buys the asset.
Step 3:
The lessor and lessee engage in a legal agreement under which the lessee will have use of the asset for the duration of the lease.
Step 4
The lessee pays for the asset’s use in instalments.
Step 5:
The lessor recoups the asset’s cost plus interest.
Step 6:
At the end of the lease arrangement, the lessee has the opportunity to purchase the asset outright.
A finance lease can have a substantial impact on a company’s financial statements in terms of accounting. Because these leases are regarded as ownership rather than rental, they have an impact on interest expenses, depreciation charges, assets, and liabilities.
A company’s balance sheet will display an increase in assets and liabilities as a result of a finance lease being capitalised, but working capital will stay unchanged. The debt-to-equity ratio, on the other hand, will rise.
The expenses associated with a finance lease will be divided into interest expenses and principal value. This is comparable to a bond or a loan. A portion of the payments will be reported as operating cash flow, while the remainder will be reported as financing cash flow. When a corporation enters into a finance lease, its operating cash flow increases.
What Does a Finance Lease Include?
Finance leases will differ depending on the demands of both the lessor and the lessee. A finance lease must be tailored to the individuals involved based on the asset being leased, the asset’s price, and the period of the arrangement. Although these agreements will vary, the following material is commonly found in most finance leases:
- Names of both parties participating in the lease, as well as their designation as the lessor and lessee
- The asset to be leased
- Asset’s total price
- The asset’s economic life
- The interest rate
- Payment schedule for principal and interest
- Penalties and fines that may apply
This lease paperwork can be highly involved, therefore it is best to speak with a business or financial services lawyer who can help ensure that the agreement is accurately formed and includes all relevant information.
The Benefits and Drawbacks of a Finance Lease
Finance leases have both advantages and disadvantages for businesses in terms of expenses, obligations, and accounting.
The following are some advantages:
- The Lessee is able to use a required asset without having to purchase it.
- Lease financing is typically less expensive than other forms of financing.
- A lessee can spread payments over several years.
- A lump-sum cost for an asset is not imposed.
- The lessee claims depreciation on the leased asset, which reduces the lessee’s tax liability.
- Even if the asset’s value grows, the lessee is simply required to pay the agreed-upon instalments.
- The lessee retains the option to purchase the asset at the conclusion of the lease period, usually at a reduced price.
The following are some of the restrictions or downsides of a bargain lease:
- The lessee is responsible for all asset upkeep and repairs.
- The lessee is responsible for all risks associated with the item.
- The lessee cannot terminate a finance lease.
Operating Lease vs Finance Lease
Comparing an operating lease vs a finance lease, we say that leases both allow a business to rent and use an asset. The primary distinction is that with a finance lease, the lessee acquires ownership of the asset. The lessee does not receive the benefits of ownership rights for accounting reasons under an operating lease.
Instalment payments for assets leased under an operating agreement are recorded on a balance sheet as a rent expenditure. They are accounted for in financial statements as the cost of sales or operating expenditures. In contrast, in a finance lease, the payments for the leased asset are recorded as amortization and interest expenditure.
Lessees in an operating lease are not accountable for the same risks that lessees in a finance lease are. The lessee in an operating lease is merely renting the asset and has only the right to utilize it. This means that the lessor keeps all of the asset’s risks and benefits. Furthermore, the lessor is liable for any maintenance or repair expenditures.
Finance Lease Examples
Finance leases are utilized in a wide range of industries, especially when a firm needs an expensive piece of equipment but wants to protect cash flow and avoid paying a huge lump payment for the essential equipment.
It can be used to lease the following assets:
- Aircraft
- Land
- Buildings
- Plant machinery
- Heavy equipment
- Ships
- Engines powered by diesel
- Patents
Is it Better to Finance a Lease or Hire Purchase?
Many organizations base their decision between a hire purchase and a finance lease on financial and accounting considerations. Normally, you must pay VAT upfront with hire buy, however with a finance lease, you can spread the expense of VAT over the monthly payments.
Some businesses opt for hire buy since the asset appears on their balance sheet.
Others, on the other hand, would like to display an asset as an operating cost and balance rentals against profit, thus they would choose a finance lease.
Another point to keep in mind concerning finance leases is that the lease period will often last for the majority of the asset’s useful life, making it a longer-term commitment than operating leases.
Finance Leases and Capital Leases
- It appears and feels like a hire purchase.
- At the end of the contract, you will not own the asset.
- The asset may or may not be shown on the balance sheet.
- The term is for the majority of the asset’s useful life.
- Ownership comes with both risks and advantages.
- Rent should be deducted from profits, and VAT should be claimed.
- You might be able to sell the item and receive a refund for the remaining leasing expenses.
Case studies in Finance Lease
Examine this case:
John Smith is alone proprietor who works as a plumber. He contracts for a finance lease on a Citroen Relay.
The agreement:
- Time frame: 48 months
- 12,500 miles per year
- The first month’s rent is £678.09 + VAT.
- Payments each month: £226.03 + VAT
- Payment in full: £6,054.75 + VAT
The business opts for smaller monthly payments and agrees on a balloon payment based on the expected resale value of the Citroen Relay. VAT payments are made as part of the monthly instalments because his company is not VAT registered.
Mr Smith chooses to pay the outstanding balloon payment and continue to use the vehicle under a peppercorn arrangement at the end of the lease.
Please keep in mind that case studies were prepared solely for illustrative purposes.
You can also pay the remaining balloon payment and run the car under a ‘peppercorn agreement,’ often known as a secondary rental agreement.
What happens when a Finance Lease Ends?
You may be given the option to renew the lease or return the asset to the finance firm at the end of the finance lease term. This depends on the conditions of the agreement, but in most circumstances, you will have the opportunity to renew your lease at the conclusion of the original lease time. If an extension is not required, the asset will be returned to the finance firm, which would generally sell it.
Alternatively, the lessee could potentially sell the asset to a third party. In this case, the lessee would act on behalf of the lessor and may be entitled to a rental rebate equal to a portion of the sales revenues. This will, once again, be determined by the conditions of the finance lease agreement.
What’s the Distinction between Leasing and Financing?
The primary distinction between contract hire leasing and finance leasing is what occurs at the end of the lease. When you lease a vehicle through a business contract hire arrangement, you are required to return it to the leasing firm (known as the ‘lessor’) in near-perfect condition at the conclusion of the contract, taking into account normal wear and tear. Damage to the vehicle or excessive mileage will result in a cost that must be paid.
You (the ‘lessee’) are responsible for selling the car to a third party at the conclusion of the contract and paying the contract with the lessor via a final balloon payment using a finance lease. As a result, any damage, extra mileage, or other faults that reduce the car’s market worth become your responsibility.
Finance Lease FAQs
Is finance lease a good option?
Because of the considerable tax benefits, it is a particularly attractive alternative for enterprises (continue reading for more information on this).
Can I get out of a finance lease?
You can cancel a car leasing arrangement at any moment, but the financial consequences may be significant depending on how much has been repaid and how your payments are structured. If you are having trouble making your payments, you should contact your finance business right away since they may be able to assist you.
When would you use a finance lease?
When purchasing large pieces of equipment, finance leasing is a viable option to outright purchase. It provides you, as a lessee, with possible cash flow advantages over outright purchase because you may be able to make payments from the equipment’s income.
