Individuals and businesses often choose to finance their use of particular assets instead of purchasing them up front. There are many reasons for this, the most obvious one being that they are not willing or (in most cases) able to raise the necessary capital to purchase the asset outright. The type of asset finance product a person chooses will depend on their individual needs. For example, they may only wish to use the asset for a short period of time, or they might want to use the asset long-term and eventually become the owner of it. In this article we will consider the various asset finance products on offer and explain the differences between each one.  

  1. What is a lease?

A lease is a contract between the owner of an asset (the “lessor”) and the user of the asset (the “lessee”), which governs the lessee’s use of the asset and the rental payments paid by the lessee to the lessor for that use over an agreed period of time.  

This is known in England and Wales as “bailment”. The bailee (lessee) has possession and use of the asset, however, ownership will not be transferred to him. The bailee will have certain rights to the asset, for example, exclusive use of the asset and he will be able to sue a person who causes damage to the asset. The bailee would be liable to the bailor in the event of the asset being damaged, and has a responsibility to take care of it.  

A lease is usually merely a financing transaction where the lessee selects the goods from the manufacturer, supplier or dealer and then chooses a lease as a finance method. The finance company lessor then buys the goods and lets them to the lessee. The lessor will expect to make a profit from the lessee’s rentals, as well as recovering the purchase price of the asset in the first place.  

There are two different kinds of lease, operating and finance, which are distinguished from each other for accounting purposes.

  1. Finance Lease

Although in law there is no difference between a finance and operating lease, for accounting purposes the two are distinguished. Statement of Standard Accounting Practice number 21 (SSAP21) and International Accounting Standard number 17 (IAS17) define a finance lease as a lease where substantially all the risks and rewards of ownership of the asset are transferred to the lessee. For SSAP21 purposes, to meet the test of being a finance lease the lessor must receive at least 90% of the initial value of the asset under the lease. For IAS17 there is a more judgemental classification. The examples given in the standard include whether there is a purchase option at significantly below fair value, or whether the lease term is for a major part of the economic life of the asset. If the lease fulfils the criteria, the asset will show as an asset of the business in the lessee’s accounts. A lease falling outwith this definition is deemed to be an operating lease and will not appear in the lessee’s accounts.  

The lessor will have little involvement with the asset or its maintenance. The asset will not normally be returned to them at the end of the lease period.  

Finance lease rentals tend to be spread evenly over the minimum period, often referred to as the “primary period”. During this time the lessee is not permitted to cancel the lease. The primary period usually covers the time in which the asset remains useful. For example, a computer will become less useful after 5 years, as it will be seen as out of date and will be unable to perform functions which newer models will be capable of.  

Once the primary period has expired, the lessee can continue to use the asset, usually at a smaller rental which will reflect the fact that the asset has depreciated in value and that the full purchase price paid by the lessor has been recovered.  

A feature of the finance lease is that the lessee will be allowed to sell the asset at the end of the primary or secondary hire, by acting as a sale agent of the lessor. The lessee will be entitled to receive the majority of the proceeds from the sale as a rebate in rentals. When the asset is sold, the lessor will take approximately 5% of the proceeds or less, in order to show that ownership had not passed to the lessee prior to the sale.  

2.1     Assets leased under finance leases:  

2.1.1     assets which the lessor would not want to have returned at the end of the primary period,  

2.1.2     assets which quickly depreciate in value,  

2.1.3     hi-tech assets,  

2.1.4     assets which are specific to the lessee’s business.  

  1. Operating Lease

An operating lease is probably the most common way in which businesses finance the use of equipment. Here, the lessee uses the asset for less than its useful life and agrees to return the asset to the lessor at the end of the agreed period.  

The rentals will equate to less than the cost of the asset, as, at the end of the period, the lessor will expect to receive the asset back and either let it to someone else or sell it.  

Unlike a finance lease, under current accounting rules the operating lease is constructed so that it will not appear on the balance sheet of the lessee’s business. The risk and rewards of ownership do not pass to a lessee in an operating lease. For the lessor, there is a risk that the value of the asset may be insufficient at the end of the lease period to allow the lessor to fully recoup his investment. This is because the lessee’s rentals plus any capital allowances plus sale proceeds received may not pay off the total cost of the asset.  

The lessor will therefore want to maximise the value of the asset at the end of the lease. In order to do this he will stipulate certain conditions in relation to the maintenance and care of the asset in the lease as to the condition of the asset at the end of the hire period. The lessee will be responsible for returning the asset to the lessor at the end of the hire period in a certain condition. He will also be expected to meet any costs payable in order to ensure that the asset is handed back in the stipulated condition.  

For example, in an operating lease of a truck the lease will set out the assumed mileage that the truck will travel over the lease period and if the milometer shows more than the specified mileage the lessee will be obliged to pay an excess mileage charge to compensate for the decreased value of the truck due to the additional miles and the extra maintenance due to the additional wear and tear.  

The faster the likely depreciation in the value of the asset throughout the hire period, the higher the rentals will be to the lessee and vice versa.  

3.1     Assets under operating leases tend to be:  

3.1.1     straight-forward and uncomplicated;  

3.1.2     low-tech; and  

3.1.3     have good second-hand potential.  

  1. Hire Purchase and Conditional Sale

Unlike finance and operating leases, hire purchase and conditional sale agreements are legal structures that allow people to finance the use of an asset and allow them to become the owner of the asset on payment of the final instalment at the end of an agreed period.  

4.1     Hire Purchase  

Hire purchase is a very widely used asset finance product. It is a form of instalment credit which allows the user of the asset to exercise an option to become the owner of it on completion of the contract. This is usually for a nominal amount, as the value of the asset will have been met by the instalments. The owner of the asset will make a profit from the hirer’s rentals, as well as covering the cost of purchasing the asset in the first place.  

Under accounting rules, hire purchase has the same treatment as finance leases, and the asset will appear on the hirer’s balance sheet.  

Hire purchase will allow the user to terminate the hiring during the hire period and return the equipment, provided that the owner of the asset is compensated for this. A hirer under a hire purchase agreement cannot sell the asset and pass title to anyone else during the hire period, with the exception of the sale of cars to private purchasers under the Hire Purchase Act 1964 Part III.  

4.2     Conditional Sale  

Conditional sale is not bailment or hiring of goods. Instead, it is a sale of goods and therefore the Sale of Goods Act 1979 applies, rather than the statute law which governs leasing and hiring. The Act imposes a number of duties on the owner and purchaser. The owner (i.e. the finance company) must pass title, deliver the asset, supply the asset at the correct agreed time and in the correct quality and quantity. The purchaser is obliged to pay the price and take delivery of the asset.  

This is similar to hire purchase, in that the purchaser pays for the asset by instalments over a certain period of time. However, unlike hire purchase, there is no option to purchase at the end of the contract, as title automatically vests in the purchaser once all of the instalments are made, provided he has not breached the agreement. When the final instalment is paid, the purchaser will become the owner, as title will pass from the finance company.  

Under the Factors Act 1889 and the Sale of Goods Act 1979, section 25, a person who is not the owner of an asset but who is the buyer of it and has possession of it with the owner’s consent (e.g. the purchaser under a conditional sale agreement) can sell the asset and pass good title to the asset to a bona fide purchaser who does not know about the conditional sale agreement. This is an exception from the legal rule that a non-owner cannot pass title where he does not have it himself.  

  1. Other Asset Finance Products

5.1     Contract Hire

This is a form of operating lease, where the lessor will supply the asset and will also provide maintenance in some way. The cost of maintenance will be included in the rentals.  

The lessor is often linked to the manufacturer of the equipment to ensure the maintenance can be easily provided. In other instances the lessor will collect the maintenance costs as the agent of the maintenance provider.  

An example of such a contract would be where a lessee is supplied with a car for a three year period with all maintenance and repairs (so far as not due to the lessee’s fault) being provided by the lessor.  

5.2     Lease Purchase This is hire purchase with some elements of leasing. Lease purchase differs from ordinary hire purchase in that no deposit is required at the outset of the hiring. At the end of the hire period the payment to purchase the asset will be more than the nominal sum in ordinary hire purchase.  

5.3     Credit Sale  

This is relatively rare but is used in employee car ownership schemes. It is similar to conditional sale in that it is a form of instalment credit allowing acquisition of the asset on deferred payment terms. However, with credit sale title to the asset passes immediately at the outset of the contract, rather than the end of the contract, so the finance company has no security in the asset.  

5.4     Contract Purchase  

This is a form of hire purchase with maintenance of the asset, whereby the owner of the asset will provide maintenance of it for the duration of the contract. The cost of such maintenance is included in the instalments paid by the hirer. It is relatively rare due to VAT difficulties and is generally only used for cars.  

5.5     Rental Agreement This is usually a short term hire of an asset, such as a car for a day or a short term charter hire of an aircraft  

  1. Tax considerations

Under the Capital Allowances Act 2001, persons who have incurred capital expenditure on the provision of plant and machinery, which they own for the purposes of a qualifying activity, are entitled to claim writing down allowances. The allowances will be calculated on 20% of the depreciating annual balance of the asset in question, or in the case of “long life assets”, 10%. Long life assets are those which have an expected useful economic life of at least 25 years.  

Although it is relatively easy to interpret what is meant by “machinery”, there has been a lot of case law surrounding the interpretation of “plant”. This has been held to include a variety of assets, including cars, machine tools, ships and oil rigs. In the case of Cole Bros Ltd v Phillips1, it was held that various items of equipment provided for fitting out a retail store should each be considered separately, as not all of the items fell within the definition of plant. The air conditioning system, electrical lighting and wiring were held not to be plant. The case of Inland Revenue Comrs v Scottish & Newcastle Breweries Ltd2 however considered murals and special period lighting in a hotel to be plant as it was part of the trade which was being carried on to create an atmosphere for customers. The key issue as to whether the asset in question is required for the furtherance of the trade, rather than being merely part of the setting where the trade is carried on.  

The trade of leasing in itself is a qualifying activity under the Capital Allowances Act. This allows leasing companies to be treated as having incurred the qualifying expenditure and as able to claim capital allowances in relation to the asset. Often, where the lessor claims capital allowances, the benefit will be passed on to the lessee in reduced rentals.  

The Finance Act 2006 introduced new rules in relation to “long funding leases”, whereby the lessee is treated as the owner of the asset for claiming capital allowances. The lessor can continue to claim the allowances in a short lease. A short lease is a lease with a term of up to five years. For leases with a term between 5 and 7 years the lessor can claim the allowances provided that the total rentals paid in any year do not vary by 5% from the rentals paid in any other year and the residual value implied at the start is not more than 5% of the fair value.  

A long funding lease allows the lessee to claim the capital allowances and has to fulfil one of the following criteria: (a) if it is accounted as a finance lease under UK GAAP or IAS, (b) the net present value of the rentals is more than 80% of the fair value of the asset, or (c) the minimum term is more than 65% of the remaining useful life of the asset.  

In hire purchase or conditional sale agreements, for capital allowance purposes the hirer is treated as the owner. The hirer is therefore able to claim the benefit of any available capital allowances. This is because with each instalment the hirer is deemed to be paying a capital instalment of the purchase price towards eventual ownership of the asset.