Finance leasing

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 capital element repaying the loan (reducing the liability in the balance sheet)

• The finance charge or interest element (which is debited to your profit and loss account).

The finance lease will therefore be reflected in your profit and loss account through a depreciation charge and a finance charge.