Meaning and definition of Financial Lease
A financial lease is a method used by a business for acquisition of equipment with payment structured over time. To give proper definition, it can be expressed as an agreement wherein the lessor receives lease payments for the covering of ownership costs. Moreover, the lessor holds the responsibility of maintenance, taxes, and insurance.
A financial lease is similar to an out-and-out purchase transaction which has been financed through a term loan, in that the payments are made on a monthly basis. However, unlike an out-and-out purchase transaction in that the lessee doesn’t present the obligated balance as debt, shows payments as expensed, and retains the equipment title. During the lease period, the finance company is considered as the legal owner of the asset.
Main features of a Financial Lease
A capital/financial lease is a commercial arrangement wherein:
- the lessee (borrower or customer) selects an asset (equipment, software, vehicle
- the lessor (finance company) purchases that asset
- the lessee uses that asset during the lease
- the lessee pays a series of installments or rentals for using that asset
- the lessor recovers a large part or almost complete cost of the asset in addition to earning interest from the rentals paid by the lessee
- the lessee has the option of acquiring ownership of the asset (bargain option purchase price or paying the last rental)
Impact of Financial Lease on Accounting
A financial lease shows the following impacts on accounting:
- Being capitalized, a financial lease leads to an increase in assets as well as liabilities present in the balance sheet. Consequently, working capital falls, but an additional leverage is created by an increase in the debt-equity ratio.
- Lease obligations are not recognized under operating lease conditions, thus, resulting in understated leverage ratios and overstated ratios of return.
- In a cash flow statement, part of lease payments are reported under operating cash flow and part under financing cash flow because of financial lease expenses being allocated between principal expense and interest expense akin to a loan or bond.