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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
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
Sara S.
With over ten years of intellectual property experience, I’m happy to work on your contractual matter. I am very diligent and enjoy meeting tight deadlines. Drafting memoranda, business transactional documents, termination notices, cease and desist 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.
Jane C.
Skilled in the details of complex corporate transactions, I have 15 years experience working with entrepreneurs and businesses to plan and grow for the future. Clients trust me because of the practical guided advice I provide. No deal is too small or complex for me to handle.
Michael M.
www.linkedin/in/michaelbmiller I am an experienced contracts professional having practiced nearly 3 decades in the areas of corporate, mergers and acquisitions, technology, start-up, intellectual property, real estate, employment law as well as informal dispute resolution. I enjoy providing a cost effective, high quality, timely solution with patience and empathy regarding client needs. I graduated from NYU Law School and attended Rutgers College and the London School of Economics as an undergraduate. I have worked at top Wall Street firms, top regional firms and have long term experience in my own practice. I would welcome the opportunity to be of service to you as a trusted fiduciary. In 2022 I was the top ranked attorney on the Contract Counsel site based upon number of clients, quality of work and top reviews.
Mathew K.
Kerbis' practice includes business and real estate transactions, estate planning, and limited scope litigation consulting. Mathew has negotiated deals involving multinational corporate franchises and has collectively helped hundreds of clients with their transactional, civil litigation, and appellate legal needs. Throughout his tenure as an American Bar Association leader, Mathew has advocated for legal education reform, interviewed ABA Presidents and State Appellate and Supreme Court Justices, and lobbied Congress on behalf of the legal profession. As a law student, Mathew served as an extern for the Honorable Justice Robert E. Gordon of the Illinois Appellate Court, First District.
Tina R.
15 years for legal experience; expertise in contracts, healthcare, ERISA, physicians, financial services, commercial contracts, employment agreements, etc. I am adept at all contracts and can provide you with efficient and quality services. I have worked at a law firm, financial services company, consulting ,and non-profit.
Meghan T.
Meghan Thomas is an accomplished transactional attorney. She specializes in IP, real estate and tech related transactional matters, and business contracts. Meghan's innovative leadership style has attributed to the firm's rapid development and presence in the metro-Atlanta market. She obtained her Doctor of Law from Emory University where she worked with the State Attorney General and litigated property disputes for disadvantaged clients. Prior to practicing, Meghan negotiated complex transactions for Fortune 500 tech and healthcare companies. She lives with her family in Southwest Atlanta, enjoys cooking, travel, dance and continues to develop her research in the areas of transactional law and legal sustainability.
January 31, 2022
Cecilia O.
With 15 years of extensive transactional/contracts experience reviewing and negotiating commercial contracts including a wide variety of purchase orders and contracts and non-disclosure agreements (NDA), I believe I can immediately contribute to the continued success of your team. I have been commended for a range of valuable skills—excellent contract management and contract administration, legal research, risk analysis, drafting and negotiations, and strategic thinking. I have worked as a legal consultant for 10+ years and I have reviewed over 7,500 contracts through this position. Contracts I have reviewed include but not limited to purchase orders, commercial and construction contracts, equipment rental agreements, non-disclosure, confidentiality, vendor agreements, service agreements, site access agreements, international agreements, request for proposals (RFP), bids and government contracts. These experiences have enabled me to master the ability to work independently and expeditiously to identify and assess issues and provide legally sound recommendations, consistent with good business practices. I have led teams (sales, insurance and management) to successfully negotiate contract terms with customers. Effective Communicator and Negotiator. I am a people person, and for the past 13 years, I have acquired excellent oral and written communication skills that enable me to interact and negotiate effectively with stakeholders at all levels. I am a self-starter with a strong work ethic. I have a high degree of resourcefulness, diligence, and dependability. Most important, I adapt to changing priorities quickly, thriving in an environment with high volume and short turnaround deadlines. My experience over the years allows me to transfer my skills to all types of contracts to meet the client’s needs. I am hopeful to provide similar legal expertise, effective contract administration and leadership to your organization. It would be a pleasure to meet within the next few weeks and discuss how my qualifications, experience, and capabilities will best fit the needs of your outfit.
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