What is a finance lease?
A finance lease or capital lease is a financial product, in which a leasing company gives operating control of an asset to a business for an agreed period, and typically at the end of the contract, the lessee will become the owner of the asset at the end of the lease, and both parties share some of the economic risks and rewards for a period of time.
Characteristics of a finance lease:
The customer chooses the assets i.e a new machine
The finance company purchases the asset
The customer makes monthly lease payments for use of the leased asset
The leasing company covers the cost of the asset plus interest
The customer has the option to take ownership of the asset after all monthly payments have been cleared
Popular for businesses when contract hire is not suitable
Advantages of finance leasing for businesses
There are many benefits that accrue to a business when using this type of lease to acquire new assets. Aside from easier cash flow management, a finance lease agreement will suit businesses that don’t want to make big upfront payments to purchase new assets, especially when the business climate is uncertain. With fixed payments over the duration of the agreement, it’s easier to budget, and avoid unexpected charges. Business owners can use the asset immediately, with only a small sum payable on the day. In addition, businesses can claim up to 50% of the VAT on cars and 100% of the VAT on commercial vehicles. There are also tax benefits, as VAT is payable on the rentals, and not the purchase price, so payments can be offset against taxable profits. Usually, there are no penalty charges for additional mileage or damage, and this will be set out in the contract. Despite the fact that you don’t technically own the asset until the end of the finance lease, you still get 98% of the sales proceeds if the asset is sold to a third party at the end of the agreement.
Why choose a finance lease?
For assets with a long useful life, it's a good option to choose a finance lease. But why not go for an operating lease? In a finance lease agreement, ownership of the asset is transferred to the lessee at the end of the lease term. In contrast, in an operating lease agreement, the ownership of the asset remains during and after the lease term with the leasing company. Flexible payments are one of the benefits of a finance lease. Lenders will work out payment plans that suit your business and cash flow needs. There are also flexible end-of-term options. What does that mean? In essence, this means that you can return the asset to the lender for resale, sell it to a third party, or choose to go for a secondary lease period.
Difference between leasing and financing
If you need to make a purchase, but don’t want to risk cash flow, there are dozens of financing options available to you. Financing effectively means funding, and this can come from a high street bank, or the many new alternative funding options. When it comes to financing, a lender will give you the money you need to buy assets or grow your business. However, leasing is different. With leasing the asset isn’t yours during the leasing agreement. You can use it as if it was yours, but you are not the legal owner of the asset until the end of the contract, and when all outstanding payments have been made to the leasing company.
Accounting treatment for UK finance leases
The great thing about finance leasing is that you have full use of an asset, let’s say a tractor, but it stays off your balance sheet. For a standard finance lease, making lease repayments is both an investment in the asset, and an interest expense. The interest element is written off over the duration of the contract, i.e the primary lease period. Thus, for the appropriate accounting treatment, it is necessary to apportion rents between the following two elements.
The rental payable should be split into two elements:
The finance lease will therefore be reflected in your profit and loss account through a depreciation charge and a finance charge.
FAQs
A finance lease is one in which risks and rewards incidental to the ownership of the leased asset are transferred to the lessee but not the actual owner. Thus, in the case of a finance lease, we can say that notional ownership is passed to the lessee.
Who owns the asset in a finance lease? ›
A finance lease or capital lease is a financial product, in which a leasing company gives operating control of an asset to a business for an agreed period, and typically at the end of the contract, the lessee will become the owner of the asset at the end of the lease, and both parties share some of the economic risks ...
What is a lease in simple terms? ›
Leases are generally legally-binding contracts between two parties: the lessor and the lessee. They involve a piece of property rented out by the owner (the lessor) to the lessee or the tenant. Leases can be verbal agreements but are normally drawn up in writing.
Do you own the vehicle at the end of a finance lease? ›
At the end of the lease, you will have no equity in the car, and no value to apply as a down payment on your next car. If you like the car and want to buy it, you'll have to take out a loan, and that loan will incur a higher interest rate since you will be financing a used car.
What happens at the end of a finance lease? ›
At the end of the finance lease period, you will usually be given the option to extend the lease beyond the primary period or to return the asset. If you don't require an extension on the finance lease, the asset will normally be returned to be sold on.
What are the risks of financial leasing? ›
Uncovering Risks in Finance Lease
The Credit Risk threatens the lessor in circ*mstances where the lessee defaults on lease payments. In essence, the lessor undergoes a potential loss of the expected income stream from the lease payments.
What is the difference between a true lease and a finance lease? ›
A true lease is typically treated as an operating expense, allowing businesses to deduct the lease payments as an operating expense for tax purposes. On the other hand, a finance lease is treated as a capital expense, enabling businesses to claim depreciation and interest expense deductions.
What is one difference between a financial lease and an operating lease? ›
A finance lease transfers the asset and any risk or return to the lessee. This means that ownership is transferred in a financial lease to the entity that leases the asset. In an operating lease, the ownership remains with the lessor, the entity that leased the asset to the lessee.
What triggers a finance lease? ›
“A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
What is the 90% test for leases? ›
What is the 90% threshold for net present value for determining whether a lease is finance or operating? If the net present value of lease payments is greater than 90% of the fair market value, then it should be classified as a finance lease and not an operating lease.
Other indicators that a lease is a finance lease include:
- At the inception of the lease the present value of the minimum lease payments* amounts to substantially all of the fair value of the asset.
- The lease agreement transfers ownership of the asset to the lessee by the end of the lease.
Introduction. A lease refers to a contract where one party grants a right to use a property or land to another party in return for consideration and for a specific period of time. Both the parties enter into a lease agreement specifying the terms and conditions of the agreement.
How are lease payments determined? ›
How is the lease payment calculated? In broad terms, you calculate a lease by determining and adding the depreciation fee, plus a monthly sales tax and a financing fee.
What do you call someone who rents out property? ›
A landlord is the owner of a house, apartment, condominium, land, or real estate which is rented or leased to an individual or business, who is called a tenant (also a lessee or renter). When a juristic person is in this position, the term landlord is used.
What is one advantage of a financial lease? ›
One advantage of a financial lease is that: it has a shorter maturity than term loans. it never appears as a liability on the balance sheet. it eliminate the needs to make periodic payments.
What is the difference between a financial lease and a private lease? ›
You are the direct economic owner and the residual value of the car is yours. With Financial Lease, unlike Private Lease, you do pay the insurance and road tax yourself. The advantage of this is that you will never lose your claim-free years.
Is a financial lease a long-term loan? ›
A finance lease is a method of financing business assets, and it works as a long-term rental agreement, with the assets remaining the property of the finance company (also known as the lessor) that hires them out, and the lessee (you) paying for the hire of the assets.
