When a contract hire arrangement is not suitable, businesses often turn to a finance lease as a preferred agreement for acquiring expensive assets.
Table of Contents:
What is a Finance Lease?
A finance lease, also known as a capital lease, is a type of Asset Finance where a leasing company grants a business operational control over an asset for a predetermined duration. At the conclusion of the lease agreement, it is common for the lessee to assume ownership of the asset. Throughout the lease term, both parties share a portion of the economic risks and rewards associated with the asset.
What are the characteristics of a Finance Lease?
The customer selects the desired assets, such as a new machine, for lease.
The finance company procures the chosen asset on behalf of the customer.
The customer makes regular monthly lease payments to utilize the leased asset.
The leasing company covers the cost of the asset, including interest charges.
Upon completion of all monthly payments, the customer has the choice to assume ownership of the asset.
This financing option is commonly favoured by businesses when contract hire is not a suitable arrangement.
What are the advantages of a Finance Lease for Businesses?
Acquiring new assets through this type of lease offers numerous advantages for businesses. One key benefit is improved cash flow management, as it eliminates the need for substantial upfront payments, which can be especially advantageous during uncertain business climates. The fixed payments throughout the lease duration make budgeting easier and help avoid unexpected expenses.
Business owners can promptly utilise the asset by making only a small initial payment. Furthermore, businesses can reclaim up to 50% of the VAT on cars and 100% of the VAT on commercial vehicles. The tax benefits are significant since VAT is payable on the rentals rather than the purchase price, enabling payments to be offset against taxable profits.
Typically, there are no penalties for additional mileage or damage, as these terms are clearly outlined in the lease agreement. Although the business doesn't technically own the asset until the end of the finance lease, they can still receive 98% of the sales proceeds if the asset is sold to a third party upon completion of the agreement.
Learn about equipment leasing here.
Why choose Finance lease?
When considering assets with a long useful life, a finance lease is often a favourable choice. However, it's worth exploring the alternative of an operating lease. In a finance lease agreement, the lessee assumes ownership of the asset at the lease term's conclusion. Conversely, in an operating lease agreement, ownership of the asset remains with the leasing company throughout and after the lease term.
One of the advantages of a finance lease is the flexibility it offers in terms of payments. Lenders collaborate with businesses to devise payment plans that align with their specific cash flow requirements. Additionally, there are flexible options available at the end of the lease term. What does this entail? Essentially, it means that businesses can opt to return the asset to the lender for resale, sell it to a third party, or even choose to enter into a secondary lease period.
What are the differences between leasing and financing?
If you find yourself in need of making a purchase while wanting to mitigate cash flow risks, there are numerous financing options at your disposal. Financing essentially involves obtaining funds, which can be sourced from traditional high street banks or the various alternative funding avenues available today. In the context of financing, a lender provides you with the necessary funds to acquire assets or expand your business.
However, leasing operates differently. In a leasing arrangement, the asset does not belong to you during the lease agreement. Despite being able to utilise it as if it were your own, legal ownership of the asset is only transferred to you at the conclusion of the contract, once all outstanding payments have been settled with the leasing company.
Accounting for UK Finance Lease
One of the notable advantages of finance leasing is that you can fully utilise an asset, such as a tractor, while keeping it off your balance sheet. In a standard finance lease, the lease repayments serve both as an investment in the asset and an interest expense. The interest component is gradually written off over the duration of the contract, known as the primary lease period. To ensure appropriate accounting treatment, it is necessary to allocate the rents between two distinct elements.
The rental payment should be divided into the following two components:
The capital element, which contributes to reducing the liability on the balance sheet by repaying the loan.
The finance charge or interest element, which is recorded as an expense in your profit and loss account.
Consequently, the finance lease will be reflected in your profit and loss account through a depreciation charge and a finance charge, providing a comprehensive representation of the lease's impact on your financial statements.
