A finance lease is a variety of equipment lease where you rent an asset for most of its serviceable lifetime. Finance leases are also identified as capital leases.
What is a finance lease?
A finance lease is a kind of equipment leasing in which the customer (or ‘lessee’) rents an item for the bulk of its service life. Finance leases are sometimes called capital leases.
Finance leases explained.
One of the most significant aspects of finance leases is that the client assumes all risks and benefits (e.g., upkeep expenditures and price fluctuations) but never actually possess the asset.
A finance lease looks and feels like a hire purchase, but they appear differently on the balance sheet.
How do finance leases work?
A finance lease is a type of long-term rental agreement in which the monthly payments will eventually equal the asset’s full cost plus interest (hence their other name, capital leases).
After the initial period has passed, the asset will generally be near the end of its usable existence. At the end of the lease term, there are usually three options:
- Continue to operate the asset in a secondary lease period (usually with lower payments).
- Sell the asset while retaining a portion of the profits.
- Return the asset to the lessor.
Finance lease or hire purchase?
Choosing between a hire purchase and a finance lease often comes down to finances and accounting for many firms. For example, you pay the VAT upfront in a hire purchase transaction, whereas you can spread the cost of VAT over the monthly payments with a finance lease.
- Because the asset is shown on a company’s balance sheet, some businesses choose to hire purchase.
- Others would prefer to show spending as an operating cost and offset rentals against profit, so they’d choose a finance lease.
Another factor to consider about finance leases is that the lease term will usually cover most of the asset’s economic life, making it a long-term commitment rather than an operating lease.
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