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 financial lease is a rental agreement where one party (lessee) rents an asset from another party (lessor) for a substantial portion of the asset's useful life. The lessee benefits almost like an owner, taking on maintenance costs and risks.
How does a finance lease work? ›
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 an option in a lease? ›
“A lease option is a contract in which a landlord and tenant agree that, at the end of a specified period, the renter can buy the property at a specified price. The tenant pays an up-front option fee and an additional amount each month that goes toward the eventual down payment.”
What is the difference between a lease option and a lease purchase agreement? ›
The difference between a lease option and a lease purchase agreement is that the lease option only obligates the seller to sell. A lease purchase agreement commits both parties to the sale barring breach of contract or the buyer's inability to secure a mortgage.
What happens at the end of a finance lease agreement? ›
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 is the disadvantage of a lease option to buy? ›
Additional costs: Lease options typically come with extra charges, such as the option fee and rent credit. Thus, you may be paying over market price for your rental as a tenant. Additionally, you stand to lose any money put toward the purchase price if you decide to pull out of the deal.
What is the meaning of leasing options? ›
A lease option is an agreement that gives a renter a choice to purchase the rented property during or at the end of the rental period. It also precludes the owner from offering the property for sale to anyone else. When the term expires, the renter must either exercise the option or forfeit it.
Is leasing a better option than financing? ›
Benefits of leasing usually include a lower up-front cost, lower monthly payments compared to buying, and no resale hassle. Benefits of buying usually are car ownership, complete control over mileage, and a firm idea of costs. Experts generally say that buying a car is a better financial decision for the long term.
How do option agreements work? ›
An option agreement is a contract between the owner of a property and a potential buyer, giving the buyer the right to serve notice upon the seller to sell the property either at an agreed price or at its market value. Often, the purchaser will pay the seller a fee for entering into an option agreement.
What is the difference between lease purchase and finance lease? ›
A hire purchase agreement allows you to own the asset at the end of the contract. With a finance lease, you rent the asset for as long as you need it, then return it. And there aren't many assets you can't acquire through leasing or hire purchase.
In summary, the advantages of leasing property include flexibility, lower upfront costs, and access to prime locations. However, it is important to carefully consider your specific needs and long-term goals before deciding whether to lease or buy.
Which of the following is the best definition of a financial lease? ›
A finance lease is a contract that permits the use of an asset and transfers ownership after the lease period is complete, and the lessor meets all other contract obligations.
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 the difference between a financial lease and a private lease? ›
In addition to Private Lease of a used car, Financial Lease is also a commonly used form. 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.
What does lease mean easy? ›
Key Takeaways. A lease is a legal, binding contract outlining the terms under which one party agrees to rent property owned by another party. It guarantees the tenant or lessee use of the property and guarantees the property owner or landlord regular payments for a specified period in exchange.
