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What Is a Finance Lease?

From operating equipment to commercial vehicles, there are many big-ticket assets that businesses might be interested in. But what are your options when you can’t afford to buy a long-term asset outright? A finance lease might be beneficial.  

What is a finance lease?

To answer the question of ‘what is a finance lease’ it’s first helpful to take a closer look at how leasing agreements work. With any lease, the lessor offers the use of equipment to the lessee in return for regular payments over the contract’s stated period.

There are many reasons why businesses might choose to lease rather than buy. For example, they might find that it makes better financial sense to lease in the short term, or they might prefer to keep assets off the balance sheet.

There are two types of accounting methods used for this type of contract, including operating and finance lease accounting. At the end of an operational lease contract, you return the asset to the lessor. However, a finance lease works differently. As the lessee, you make your regular payments as stated in the lease contract. However, instead of returning it to the lessor, you then usually agree to pay a residual value to the lessor. This gives you the option of purchasing the asset or entering into a new agreement based on residual value.

Finance lease vs. operating lease

There are several key differences to take note of when looking at a finance lease vs. operating lease. Finance lease accounting is different, as is the issue of ownership and risk.

Finance lease:

  • The lessee can buy the asset at the end of the lease term with a successful ‘offer to buy’.

  • A successful offer will be the balloon amount or residual amount of value.

  • The balloon or residual value is set using Australian Tax Office (ATO) asset guidelines.

  • Legal ownership transfers to the lessee at the conclusion of the lease term.

  • Running costs are charged separately to the monthly repayment amount.

  • The item is reported as an asset on the balance sheet.

Operating lease:

  • The lessee can finance the asset for less than its full lifespan.

  • At the end of the lease period, the lessee can return the asset with no further obligation.

  • Ownership is retained by the lessor both during and after the lease term.

  • All operating costs are included within the lease under a set monthly repayment.

  • Operating lease items were treated as expenses until 2019. They are now recorded as liabilities on the balance sheet.

As you can see, the ins and outs of these lease contracts are quite different. When looking at operating and finance lease terms, it’s also important to note that the lessee is responsible for risk under a finance lease. By contrast, the lessor assumes risk with an operating lease.

Finance lease examples

The most common finance lease example is seen in car financing. Imagine that you need a commercial vehicle for your business. With a finance lease situation, you’re able to use the car for your business purposes just as an owner would and assume all risk. At the end of the lease term, you make your residual payment to the financier, after which point you legally own the vehicle. It’s treated as an asset on the balance sheet throughout the lease.

Another finance lease example would be a piece of machinery used in your business’s factory. As with the car, you make regular monthly payments to the lessor for the duration of your contract. At the conclusion of the contract, you purchase the machinery using its remaining value in a single balloon payment.

Is a finance lease right for you?

There are pros and cons to both a finance and operating lease, so the best option will depend on your circumstances. On the one hand, operating lease agreements involve less administration and hassle. You make your payments, and hand the asset back at the conclusion of your contract.

However, if you ultimately wish to own the asset but can’t currently afford to buy it outright, a finance lease could be a good solution. You get all the benefits of a shiny new asset, without the massive upfront cost.

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