Finance Lease: What's Included, Advantages and Disadvantages

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Quick Facts — Finance Lease Lawyers

What is a Finance Lease?

A finance lease, also referred to as a capital lease or sales lease, is a type of commercial lease in which a finance company is the legal owner of an asset, and the user rents the asset for an agreed-upon period of time. In this legal contract, the leasing company, usually the finance company, is called the lessor, and the user of the asset is called the lessee.

When a lessee enters into this agreement, they have operating control over the asset. They take responsibility for all the risks and rewards associated with the ownership of the asset. For accounting purposes, the lease provides the lessee with economic characters of ownership of the asset.

The lessee will record the asset as a fixed asset in their general ledger. In this situation, the lessee will record the interest of the lease payment as an expense.

To be classified as a finance lease under US GAAP, the rental contract must meet at least one of the following requirements:

  • The present value of the lease rentals is equal to or greater than the fair market value of the asset
  • The lease term is more than 75% of the leased asset’s useful life
  • The option to purchase the leased asset at a lower price than the fair value of the leased asset is given to the lessee.
  • The legal ownership of the leased asset transfers from the lessor to the lessee at the end of the lease.

In an IFRS jurisdiction, however, a lease is classified as a finance lease if all of the following basic criteria are met:

  • Throughout the duration of the lease period, the lessor remains the legal owner of the asset
  • The risk and rewards related to leased assets are transferred to the lessee
  • Legal ownership of leased asset transfers from the lessor to the lessee after the end of the lease.

For more information about finance leases and their impact on a company’s accounting, click here.

How a Finance Lease Works

A finance lease is essentially a commercial rental agreement where the following steps take place:

Step 1: The lessee selects an asset that they require for a business.

Step 2: The lessor, usually a finance company, purchases the asset.

Step 3: The lessor and lessee enter into a legal contract in which the lessee will have use of the asset during the agreed upon lease.

Step 4: The lessee makes a series of payments for the use of the asset.

Step 5: The lessor recovers the cost of the asset plus interest.

Step 6: At the end of the lease agreement, the lessee has the option to acquire ownership of the asset.

For accounting purposes, a finance lease can have significant impacts on a company’s financial statements. These types of leases are viewed as ownership rather than a rental, so they influence interest expenses, depreciation expenses, assets, and liabilities.

Due to a finance lease being capitalized, a company’s balance sheet will reflect an increase in assets and liabilities but working capital will remain the same. The debt and equity ratio, however, will increase.

The expenses related to a finance lease will be split between interest expenses and principal value. This is similar to a bond or a loan. Part of the payments will be reported under operating cash flow, and the other part will be reported under financing cash flow. This causes operating cash flow to increase when a company is involved in a finance lease.

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What’s Included in a Finance Lease

Finance leases will vary based on the specific needs of both the lessor and the lessee. Depending on the asset being leased, the price of the asset, and the term of the agreement, a finance lease will have to be tailored to the individuals involved.

Although these agreements will differ, it is common to find the following information in most finance leases:

  • Names of both parties involved in the lease and designation as the lessor and the lessee
  • Asset to be leased
  • The total price of the asset
  • The economic life of the asset
  • Interest rate
  • Principal and interest payment schedule
  • Associated penalties and fees

This lease document can be very complicated, and it is best to consult with a business lawyer or financial services lawyer who can help ensure that the agreement is drafted correctly and includes all pertinent information.

Advantages and Disadvantages of a Finance Lease

Finance leases offer companies both advantages and disadvantages as far as costs, liabilities, and accounting.

Some advantages are as follows:

  • The Lessee is able to use a needed asset without purchasing it
  • Lease financing is usually less expensive than other types of financing options
  • A lessee is able to spread payments out over several years
  • There is no burden of a lump-sum cost for an asset
  • The lessee claims depreciation on the leased asset reducing tax liability
  • Even if the asset rises in price, the lessee only has to pay the installments already agreed upon
  • The lessee retains the right to purchase the asset at the end of the lease period, usually at a bargain rate

Some limitations or disadvantages of a bargain lease include the following:

  • The lessee is responsible for all maintenance or repairs on the asset
  • The lessee is liable for all risks involved with the asset
  • The lessee cannot cancel a finance lease

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Finance Lease vs. Operating Lease

Both operating leases and finance leases allow a company to rent and use an asset. However, the main difference is that under a finance lease, the lessee conveys ownership of the asset. Under an operating lease, the lessee does not get the benefits of ownership rights for accounting purposes.

Installment payments for assets leased under an operating agreement are recognized as a rent expense on a balance sheet. They are recorded in financial statements under the cost of sales or operating expenses. This is different from a finance lease, where the payments for the leased asset are recorded as an amortization expense and interest expense.

Lessees involved in an operating lease are not liable for the same risks as lessees involved in a finance lease. In an operating lease, the lessee is simply renting the asset and only has the right to use. This means that the lessor retains all of the risks and benefits associated with the asset. In addition, the lessor is responsible for all maintenance or repair costs.

To read more about the similarities and differences between finance leases and operating leases, check out this article.

Examples of Finance Leases

Finance leases can be found in a wide variety of industries and are used primarily when a company requires an expensive piece of equipment but wants to preserve its cash flow and avoid paying a large lump sum for the required equipment.

Some examples of assets that are leased through finance leases include:

  • Aircraft
  • Land
  • Buildings
  • Plant equipment
  • Heavy machinery
  • Ships
  • Diesel engines
  • Patents

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ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.


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Lawyer Reviews for Finance Lease Projects

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Business Contracts

Finance Lease

New York

Asked on Jun 16, 2024

What are the legal implications and potential risks associated with entering into a finance lease agreement?

I am considering entering into a finance lease agreement for a piece of machinery for my small business, but I am unsure of the legal implications and potential risks involved. I have been approached by a leasing company that is offering attractive terms, but I want to ensure that I fully understand my rights and obligations before committing to the agreement. I have heard conflicting opinions from colleagues about the potential risks associated with finance leases, such as hidden fees, early termination penalties, and the potential for the lessor to reclaim the asset. I would like to consult with a lawyer to gain a better understanding of the legal aspects and any potential pitfalls before making a decision.

Damien B.

Answered Jun 25, 2024

This is Attorney Damien Bosco. My law office is in Forest Hills, Queens County, New York City. My practice covers the New York City metropolitan area and Long Island. In some situations, I also handle matters throughout New York State. It appears that you have considered the risks involved. I would say that a significant concern is the possibility of defaulting on payments, which could lead to the lessor reclaiming the equipment due to a security interest indicated by a UCC filing. Lease provisions are often negotiable. Have an attorney specializing in commercial law review the lease to ensure it protects your interests.

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Commercial Real Estate

Finance Lease

Georgia

Asked on Mar 10, 2025

What are the legal implications of entering into a finance lease agreement?

I am considering entering into a finance lease agreement for a commercial property, and I would like to understand the legal implications before making a decision. I have been approached by a leasing company that is offering favorable terms, such as lower upfront costs and fixed monthly payments, but I am uncertain about the potential risks and responsibilities involved. I want to ensure that I am fully aware of my legal obligations and rights under a finance lease agreement before proceeding.

Jerome L.

Answered Apr 8, 2025

Hi there, A finance lease agreement can be a practical way to acquire commercial property or equipment with lower upfront costs and fixed payments—but it comes with specific legal obligations and long-term commitments that you should fully understand before signing. Here are the key legal implications to consider: Legal Considerations in a Finance Lease Agreement: Binding Long-Term Obligation: A finance lease is typically non-cancellable during the lease term, meaning you are legally obligated to make payments for the entire duration, even if you no longer need the property. Ownership vs. Use: You do not own the property under a finance lease. You are leasing it for an extended period, often with an option to purchase at the end. However, all the risks and responsibilities of ownership—like maintenance, insurance, and taxes—may still fall on you. Lessor’s Ownership Rights: The leasing company retains title to the property during the lease term. If you default, they typically have the right to repossess the property and pursue you for any remaining balance. Fixed Monthly Payments (But Watch for Hidden Costs): While the fixed payments seem attractive, be sure to review: Interest rates Late fees or penalties Additional service charges or fees tied to property upkeep End-of-Term Options: Understand your rights at the end of the lease: Can you buy the property? Are there residual value payments? Will you owe fees for wear-and-tear or restoration? Termination & Default Clauses: Read the fine print on what constitutes default and whether the lessor can accelerate payments or take legal action if you miss a payment. Impact on Financial Statements: A finance lease may appear as a liability on your balance sheet, depending on how the lease is structured. It’s wise to consult with an accountant on this point too. Before moving forward, I highly recommend having the lease agreement reviewed by an attorney. This will ensure the terms are fair, your risks are understood, and you are fully protected. If you would like assistance reviewing or negotiating the terms of your finance lease, I am happy to help. Best regards, Jerome Lucas Newell, Esq. Commercial Lease & Business Contracts Attorney

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