Finance Lease: What's Included, Advantages and Disadvantages
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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.
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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Meet some of our Finance Lease Lawyers
Jeremiah C.
Jeremiah C.
Creative, results driven business & technology executive with 27 years of experience (17+ as a business/corporate lawyer). A problem solver with a passion for business, technology, and law. I bring a thorough understanding of the intersection of the law and business needs to any endeavor, having founded multiple startups myself with successful exits. I provide professional business and legal consulting. Throughout my career I've represented a number large corporations (including some of the top Fortune 500 companies) but the vast majority of my clients these days are startups and small businesses. Having represented hundreds of successful crowdfunded startups, I'm one of the most well known attorneys for startups seeking CF funds. I hold a Juris Doctor degree with a focus on Business/Corporate Law, a Master of Business Administration degree in Entrepreneurship, A Master of Education degree and dual Bachelor of Science degrees. I look forward to working with any parties that have a need for my skill sets.
"Jeremiah was pleasant to speak to and provided high quality work. I appreciate that he took the time to call me personally instead of a paralegal. Work delivered early and high quality! Highly recommend"
Ryenne S.
My name is Ryenne Shaw and I help business owners build businesses that operate as assets instead of liabilities, increase in value over time and build wealth. My areas of expertise include corporate formation and business structure, contract law, employment/labor law, business risk and compliance and intellectual property. I also serve as outside general counsel to several businesses across various industries nationally. I spent most of my early legal career assisting C.E.O.s, General Counsel, and in-house legal counsel of both large and smaller corporations in minimizing liability, protecting business assets and maximizing profits. While working with many of these entities, I realized that smaller entities are often underserved. I saw that smaller business owners weren’t receiving the same level of legal support larger corporations relied upon to grow and sustain. I knew this was a major contributor to the ceiling that most small businesses hit before they’ve even scratched the surface of their potential. And I knew at that moment that all of this lack of knowledge and support was creating a huge wealth gap. After over ten years of legal experience, I started my law firm to provide the legal support small to mid-sized business owners and entrepreneurs need to grow and protect their brands, businesses, and assets. I have a passion for helping small to mid-sized businesses and startups grow into wealth-building assets by leveraging the same legal strategies large corporations have used for years to create real wealth. I enjoy connecting with my clients, learning about their visions and identifying ways to protect and maximize the reach, value and impact of their businesses. I am a strong legal writer with extensive litigation experience, including both federal and state (and administratively), which brings another element to every contract I prepare and the overall counsel and value I provide. Some of my recent projects include: - Negotiating & Drafting Commercial Lease Agreements - Drafting Trademark Licensing Agreements - Drafting Ambassador and Influencer Agreements - Drafting Collaboration Agreements - Drafting Service Agreements for service-providers, coaches and consultants - Drafting Master Service Agreements and SOWs - Drafting Terms of Service and Privacy Policies - Preparing policies and procedures for businesses in highly regulated industries - Drafting Employee Handbooks, Standard Operations and Procedures (SOPs) manuals, employment agreements - Creating Employer-employee infrastructure to ensure business compliance with employment and labor laws - Drafting Independent Contractor Agreements and Non-Disclosure/Non-Competition/Non-Solicitation Agreements - Conducting Federal Trademark Searches and filing trademark applications - Preparing Trademark Opinion Letters after conducting appropriate legal research - Drafting Letters of Opinion for Small Business Loans - Drafting and Responding to Cease and Desist Letters I service clients throughout the United States across a broad range of industries.
"Ryenne was professional and very helpful. Her review of our agreement broke down the legal jargon into laymens terms and helped our team discussions for the decision making process ~ Thank you!"
Sara S.
With over eleven years of intellectual property experience, I’m happy to work on your contract problem. I am very diligent and enjoy meeting tight deadlines. Drafting memoranda, business transactional documents, termination notices, demand letters, licenses and letter agreements are all in my wheelhouse! Working in a variety of fields, from construction to pharmaceutical, I enjoy resolving any disputes that come across my desk. I will prioritize your project, big or small. Please be ready and prepared with all relevant documentation so we can get started as soon as you click HIRE! Hourly rate projects will be billed hourly in accordance with the timesheet. Flat rate projects will be billed in segments. Choosing an hourly or flat rate is up to you. Absolutely no refunds.
"Sara was very helpful with the matter and we will work with her again."
Travis D.
Travis counsels individuals and businesses on a broad range of complex topics. His practice centers on producing efficient, client-driven results. He concentrates his practice on real estate, construction, and general business matters with an emphasis on assisting clients both before and after problems occur by drafting contracts designed to best position clients to avoid disputes and litigating matters to a final resolution if problems emerge. Born and raised in Oklahoma, Travis is a triple graduate of the University of Oklahoma, having obtained his Bachelor of Arts, Master of Business Administration, and Juris Doctor degrees from OU. Prior to practicing law, Travis managed the finances and business operations of a successful construction supply company for several years. This insight into sophisticated business dealings, contractual issues, and strategic planning makes him uniquely qualified to handle a wide range of legal matters. Travis lives in Norman with his wife, Haley, dogs, Walter and Poppy, and cat, Ernest. Outside of the office, Travis enjoys playing golf and reading.
"What a great service! Will definitely recommend to family and friends!"
Justin C.
Justin Camper is a small business and trademark attorney, entrepreneur, public speaker, and writer. Justin has been practicing law close to 5 years and has done various areas of law from criminal work as a Prosecutor, to business and civil litigation at private law firms.
"Justin C did a great job. I will recommend Contractscounsel to friends"
August 9, 2022
Bolaji O.
Bolaji O. Okunnu is an entertainment lawyer and founder of the Okunnu Law Group, PLLC based in New York, New York. His practice includes work in the area of copyright, trademark, contract, intellectual property and business law. As an entertainment attorney, Bolaji represents a diverse roster of celebrities, record labels, music publishers, artists, bands, entrepreneurs, authors, songwriters, artist managers, record producers and entertainment executives concerning their intellectual property, business affairs and creative assets. He is an expert at solving complex and sophisticated legal and business issues relating to contracts, copyrights and trademarks. With his background in both the law and the music business, he brings a broad perspective to problem-solving and business plan strategies. He also has an extraordinary ability to speak to the hearts of creatives while helping them discover their voice and clarify their creative dreams and assignments.
Matt M.
I love to learn, and I love solving problems. That's why I became a lawyer, and learned to solve legal problems for individuals and businesses and help them fix things when there's a snag. Touch base if you think I could have something to offer for you or your company. Experienced, results-oriented legal professional whose background and education have established him as a valuable resource in areas of corporate law, franchising, litigation, compliance, mortgages and banking, and more. Practice Areas Include: Corporate law, Franchising, Litigation, real estate, corporate law, civil disputes, insurance representation, corporate counseling, dispute resolution, risk management, regulatory counsel, compliance. Experience involves sophisticated as well as routine corporate structuring and transactions, simple and complex litigation, and written and oral advocacy such as depositions, mediated settlement conferences, trials, appeals, written pleadings and discovery, and case strategy and analysis. Experience managing and litigating disputes between parties and negotiating settlements across the spectrum of civil litigation, including probative discovery, successful motions practice, legal research and writing, appellate practice, and legal consultation to individuals and business entities. Further experience includes digesting and monitoring updates to the legal landscape to advise clients or departments and successfully adapt policies and procedures to assure compliance with applicable laws and regulations as well as to manage risk effectively. For those needing a skilled commercial or corporate lawyer, or for individuals whose rights need persuasive advocacy, I am a valuable resource. Representative work also has involved success on the appellate level, as in Baker Construction Company, Inc. v. City of Burlington and Hawthorne, LLC, North Carolina COA09-13.
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Facility Finace Contract Review
"Great work! Thanks so much for the detailed feedback!"
Business Contracts
Finance Lease
New York
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.
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.
Commercial Real Estate
Finance Lease
Georgia
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.
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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