If you’re considering leasing equipment or vehicles for your business, you’ve likely come across the terms ‘finance lease’ and ‘operating lease.’ While both involve leasing an asset rather than purchasing it outright, a finance lease differs from an operating lease in important ways.
Explore what a finance lease is, how it works, and what distinguishes it from other leasing options.
By the end, you’ll have a solid understanding of this common business leasing arrangement.
What is a Finance Lease?
Let’s begin with defining what exactly a finance lease is. In simple terms, a finance lease is a type of agreement where the lessee (the party leasing the asset) takes on most or all of the responsibilities, risks, and costs of maintaining ownership of the asset. This differs from the structure of an operating lease, which we’ll explore later.
A finance lease allows a business to acquire equipment or vehicles while avoiding large upfront capital outlays. However, through the terms of the finance lease agreement, the lessee essentially takes on the role of the asset’s owner during the lease period. Now that we have a basic definition, let’s dive deeper into the key characteristics that distinguish a finance lease.
One such characteristic is that finance leases typically span the bulk of an asset’s useful life. For instance, the lease period for a piece of manufacturing machinery under a finance lease may cover seven years when its overall useful life is estimated at 10 years. By contrast, operating leases tend to be shorter-term. Related to this, another distinguishing feature is that the present value of lease payments due under a finance lease is usually substantially similar to the fair market value of the leased property. So essentially, the lessee pays an amount over the lease term that approximates the full purchase price.
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Finance lease
Taking a look at which party bears the risks and responsibilities further underscores that a finance lease transfers ownership benefits and burdens to the lessee. Under the terms of a finance lease agreement, the lessee is responsible for ongoing maintenance, repairs, property taxes, and insurance on the leased asset. They also shoulder the risk of damage or destruction. At the end of the lease period, the lessee has the option to purchase the asset at a bargain price, continuing ownership. On the other hand, the lessor (owner/financing party) can often remove themselves from involvement once the lease begins.
To illuminate these ownership qualities even more, consider a key difference between car leasing and a finance lease: with a standard auto lease, the leasee simply drives the car for a period of time but doesn’t truly take ownership. Comparatively, a business that obtains a vehicle through a finance lease agreement would more closely resemble outright ownership – handling repairs and other duties throughout the lease.
Given that these factors make the lessee largely responsible as the deemed owner, a finance lease is treated as an asset on the company’s balance sheet. The property is listed as an asset and the lease obligation is shown as a liability. This differs from accounting for an operating lease which remains off-balance sheet.
About 60% of commercial equipment leases in the United States are finance leases according to leasing industry sources.
The equipment type and dollar amounts involved also influences whether a finance lease makes more business sense. Larger, long-term assets that hold value such as manufacturing machinery commonly use finance leases.
So in summary, a finance lease transfers most of the responsibilities of ownership to the lessee, emulating the risks and benefits of borrowing money to purchase the asset outright. The lease payments essentially pay off purchasing the asset over the lease term. While equity is not built like with an owned asset, a finance lease provides businesses the flexibility to acquire expensive equipment without large upfront costs. The lessee essentially takes the asset as their own on the balance sheet as well.
What is the difference between a finance lease and an operating lease
Now that we have examined the core characteristics of a finance lease, let’s conclude by reviewing the key differences from an operating lease:
- Finance leases typically cover most or all of an asset’s useful economic life whereas operating leases are usually shorter-term.
- Lessees are responsible for maintenance, repairs, taxes and insurance under a finance lease but may not for an operating lease.
- Ownership risks like damage or loss fall to the lessee in a finance lease arrangement.
- Finance leases often allow lessees to purchase the leased asset at a bargain price at the end of the term, acting as the deemed owner.
- From an accounting standpoint, leased assets show up on the lessee’s balance sheet under a finance lease while operating leases remain off-balance sheet.
I hope this overview has equipped you with a strong understanding of what a finance lease entails and how it differs from other lease options. Comparing the fundamental characteristics can help businesses determine whether a finance lease or operating lease structure best suits their specific equipment or vehicle financing needs. With the right lease agreement, asset acquisition goals can be achieved efficiently.