A financial lease can be defined as a process used by a business for purchasing of equipment with payment prearranged over time. It can be further termed as an agreement in which the lessor gets lease payments for the covering of ownership costs. In addition, the lessor owns the responsibility of insurance and taxes along with its maintenance.
Furthermore, financial lease is more or less similar to an out-and-out purchase transaction that has been financed through a tenure loan. In this method the payments are made every month. However, here the lessee does not give the obligated balance as liability unlike an out-and-out purchase transaction. In fact it shows payments as expensed, and keeps the title of the asset purchased.
Features of Financial Lease
Finance lease can also be expressed as a commercial arrangement where:
- The customer or borrower (lessee) will choose an asset of his choice. This could be vehicle, equipment or software;
- The finance company (lessor ) will buy that asset;
- The customer will use that asset during the lease period;
- The finance company on behalf of the customer will pay a series of installments for that asset;
- The finance company than will recover a major portion or all of the cost of the asset in addition to the interest from the installments paid by the customer;
- The customer has the choice to purchase ownership of the asset by paying the last installment or bargain option purchase price;
The finance company (lessor) is considered to be the legal owner of the equipment/ asset during the lease period. However the lessee is in charge of the asset providing them the remuneration and risks of ownership.
Impact of Financial Lease on Accounting
Financial lease has different impacts on accounting which are explained below as following:
- It leads not only to an increase in assets but also in debts which are given in the balance sheet. As a result, there is a fall in the working capital, but at the same time an additional leverage is produced by an increase in the debt-equity ratio.
- Understated leverage ratios and overstated ratios of return results when lease obligations are not documented under the conditions of an operating lease.
- A part of lease payments are sated under operating cash flow in cash flow statement and part under financing cash flow since financial lease expenses owed between principal expense and interest expense are similar to a loan/ bond.