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:
In an IFRS jurisdiction, however, a lease is classified as a finance lease if all of the following basic criteria are met:
For more information about finance leases and their impact on a company’s accounting, click here.
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.
Meet some lawyers on our platformFinance 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:
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.
Finance leases offer companies both advantages and disadvantages as far as costs, liabilities, and accounting.
Some advantages are as follows:
Some limitations or disadvantages of a bargain lease include the following:
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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.
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:
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.
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