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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:
- Plant equipment
- Heavy machinery
- Diesel engines
Get Help with a Finance Lease
Do you have questions about finance leases and want to speak to an expert? Post a project on ContractsCounsel today and receive bids from business lawyers and finance lawyers who specialize in finance lease agreements.
Meet some of our Finance Lease Lawyers
David H. Charlip, the principal of Charlip Law Group, LC, is one of only 101 Board Certified Civil Trial Lawyers in Miami-Dade, with over 38 years of litigation experience. Mr. Charlip is also one of only 136 Florida Civil Law Notaries. He has managed and litigated cases across the country. Mr. Charlip has advised businesses, drafted business formation and purchase and sale documents and litigated business disputes for over 30 years and is very familiar with all aspects of contractual relations.
With over 16 years of experience in the area of estate planning, trademarks, copyrights and contracts, I am currently licensed in Florida and NJ. My expertise includes: counseling clients on intellectual property availability, use and registration; oversee all procedural details of registration and responses with the USPTO/US Copyright Office; negotiate, draft and review corporate contracts and licensing; counsel clients on personal protection, planning and drafting comprehensive estate plans.
Melissa Taylor, the President and founding partner of Maurer Taylor Law, specializes in business contract review and drafting and is a second-generation attorney with private firm, in-house counsel, governmental, entrepreneurial, and solo practitioner experience. Melissa has a strong legal background, a dedication to customer service, is friendly, warm and communicative, and is particularly skilled at explaining complex legal matters in a way that's easy to understand. Melissa personally handles all client matters from start to finish to ensure client satisfaction.
Lawrence A. “Larry” Saichek is an AV rated attorney and a CPA focusing on business and real estate transactions, corporate law and alternative dispute resolution. With a background including five years of public accounting and six years as “in house” counsel to a national real estate investment company, Larry brings a unique perspective to his clients – as attorney, accountant and businessman. Many clients think of Larry as their outside “in house” counsel and a valued member of their team. Larry is also a Florida Supreme Court Certified Mediator and a qualified arbitrator with over 25 years of ADR experience.
Entertainment Attorney with 30+ years of experience, representing all aspects of the TV, Film, Music and Publishing Industries
Aaron focuses his practice on startups and emerging growth companies, providing general counsel services for companies from formation through exit. Aaron frequently advises clients in connection with routine and unique legal, business, and strategic decisions, including corporate, business and technology transactions, angel and venture financings, mergers and acquisitions, protection of intellectual property, and information privacy and data security.
I enjoy helping businesses of all sizes succeed, from start-ups to existing small and medium sized businesses. I regularly advise corporate clients on a variety of legal issues including formation, day to day governance, reviewing and drafting business contracts and other agreements, business acquisitions and sales, as well as commercial and residential real estate issues, including sales, purchases and leases. As an attorney licensed in both Michigan and Florida, I also advise clients on real estate issues affecting businesses and individuals owning real property in either state, whether commercial, residential or vacation/investment property. I also regularly assist nonprofit organizations in obtaining and maintaining tax exempt status, and provide general legal counsel on all matters affecting public charities, private foundations and other nonprofit organizations.