Asset management tends to be one of the most important tasks of a managerial accountant. In this regard, the managerial accountant needs to ensure that they can investigate all the possible options for financing assets that are required by the company so that they can determine the best possible course of action for the company.
Regarding asset financing, financial lease, and hire purchases are considered the top choices for companies because of their relative advantages compared to traditional financing tools.
What is Financial Lease?
A financial lease can simply be defined as a contract between the customers and the equipment suppliers for using a particular asset against periodic payments, referred to as lease payments.
All lease contracts involve a lessee (the user of the asset) and the lessor (the original owner of the asset).
In the case of the financial lease, capitalization of the asset is upfront. Once the lease agreement is signed, the lessee can capitalize the asset in the financial statements.
However, the corresponding credit entry would be the outstanding lease liability, which will be periodically reduced as subsequent lease payments are considered.
A financial lease also referred to as a capital lease is a contract between two parties, one of which wants to use the asset, and the other party, has the asset ownership.
Certain criteria must be fulfilled for a lease to be classified as a financial lease. These criteria are summarized below:
- Ownership of the asset is transferred to the lessee at the end of the lease contract.
- A bargain purchase option gives the lessee the option to procure the asset at a discounted price at the end of the term.
- The lease term should be greater than or equal to 75% of the asset’s useful life.
- The present value of the lease payments should be greater than or equal to 90% of the asset’s fair market value.
Therefore, the financial lease is considered long-term, since it spans most of the asset’s useful life.
It is considered a top choice for organizations because it allows them to use the asset without paying a hefty amount in line for procuring it.
What is Hire Purchase?
Hire purchase is referred to as an arrangement that involves purchasing assets of a considerable amount. In other words, hire purchase is a type of asset finance that allows firms or individuals to possess and control an asset during an agreed term.
However, the asset user is supposed to pay rents, installments that cover the depreciation of the asset, as well as interest required to cover the capital cost of the asset.
During hire purchase contracts, there is an understanding that the owner of the asset will transfer the ownership rights once all installments have been paid for.
This implies that before the event of all installments being paid, the asset user cannot capitalize it in the financial statements, and would only do so once the payments have been transferred.
Hire Purchase is considered a financing solution suitable for businesses that want to purchase assets in the long run, without having to pay the full cost of the asset upfront.
This might either be because of the lack of liquid resources or because of the relative opportunity cost involved in investing in cash in an upfront manner.
Hire Purchase works with the customer making an initial deposit, with the remainder of the balance and interest being paid over time.
Upon completion, the ownership of the asset is duly transferred to the user of the asset. However, hire purchase is mostly used in scenarios where the overall price of the asset is considerably less.
Therefore, at the end of the period, the party that has procured the asset for use ends up buying the asset.
However, the ownership transfer can only occur once all installments have been paid for.
Key Differences between Financial Lease and Hire Purchase
Hire purchase is often perceived to be a subcategory of leasing. However, hire purchase agreements are structured differently than typical leasing contracts.
The fundamental difference between a financial lease and a hire purchase tends to be that in the financial lease, there is no necessary intent of purchasing the asset at the end of the contract.
However, the organization normally purchases the asset in the case of a hire purchase.
The key differences between a finance lease and a hire purchase have been summarized has been summarized in the table below:
|Ownership of the asset lies with the lessor.
The Lessee does not have the right to purchase the asset unless it is a capital lease.
|The hirer has the option to purchase the asset after all the installments have been paid.
Therefore, in most hire purchase cases, there is a definite transfer of ownership.
|Ownership can be transferred at the beginning of the lease period in case of a financial lease.
Normally, the asset is capitalized as a summation of the present value of the lease payments that are supposed to be made.
The relevant credit entry is undertaken in the lease payments.
|Ownership is only transferred only after all the installments are paid.
Before the installments are paid, the organization that has procured the asset cannot possibly record it as an asset in its financial statements.
|Depreciation is claimed as an expense in the lessor’s books unless it’s a financial lease.
|Depreciation of the asset is allowed to the individual contracting the hire purchase.
This is because the asset will be transferred to the organization that is using the asset. Hence, it makes sense for them to depreciate it in their books.
|Rental payments cover the cost of the asset. The lump-sum figure of the lease payments includes several different components.
These lease payments will have an interesting figure embedded already.
|Installments are designed to include both, the principal, as well as the interest amount. The interest rate charged on the hire purchase is a flat rate.
|A financial Lease spans a longer time duration. The cost of the asset is considerably high.
Therefore, it spreads over a considerably significant period.
|Hire Purchase spans over a shorter time duration.
The cost of the underlying asset is also low, therefore, they are not spread across a considerable period.
|In the case of the operating lease, the responsibility of maintaining the asset lies with the lessor.
If a financial lease is drawn, only then does the ownership responsibility lie with the lessor.
|In Hire Purchase, all asset maintenance costs are borne by the individual that has procured the asset.
|For financial lease contracts, there is no down payment involved.
It is a complete financial option and does not involve an upfront cost unless stated in the contract.
|Most hire purchase contracts involve an upfront cost that needs to be paid by the organization that is procuring the asset.
Therefore, it is considered to be a partial financing scheme, which requires both, a down payment, as well as periodic costs.
Which situation is hire purchase better than lease?
A hire purchase is a better option in several situations than a lease. Consider the following factors:
Ownership: If you want to own the asset at the end of the contract, a hire purchase is the preferred choice.
With a hire purchase agreement, you make regular payments towards the asset’s purchase price, and once the contract is completed, ownership transfers to you.
On the other hand, with a lease, you typically return the asset at the end of the lease term.
Credit Score: If you have a good credit score, you are more likely to qualify for hire purchase financing.
Leasing may be more challenging or result in higher interest rates if your credit score could be stronger.
So, if you have a good credit history, a hire purchase provides a more accessible financing option.
Depreciation Costs: If you want to claim depreciation costs for tax purposes, a hire purchase is a suitable choice.
You can generally claim depreciation expenses as the asset owner under-hire purchase.
Leasing, however, provides a different benefit, as you are not the asset owner.
Monthly Payments: Hire purchase agreements often involve higher monthly payments than lease agreements.
This is because you are paying off the full purchase price of the asset over the contract term.
If you can afford higher monthly payments, a hire purchase allows you to build equity in the asset more quickly.
Deposit and Early Termination Fees: With hire purchase, it is common to pay a deposit upfront.
This deposit reduces the total amount financed and may be required to secure the asset.
Additionally, if you decide to terminate the hire purchase contract early, you may have to pay early termination fees.
Leasing may have different terms regarding upfront payments and early termination fees, which can vary.
Which situation is lease better than hire purchase?
In certain circumstances, leasing can be a more suitable choice than a hire purchase.
Let’s explore the situations where leasing becomes the better option:
- Ownership Preference: If your intention is not to own the asset at the end of the contract and you simply require its use for a specific period, leasing provides the ideal solution. Leasing allows you to utilize the asset without the burden of ownership responsibilities, making it a convenient choice for those who prioritize flexibility.
- Credit Score Consideration: Obtaining a hire purchase agreement might prove challenging if you have a poor credit score. Lenders may be hesitant to approve your application or may require higher interest rates due to the perceived risk. However, leasing companies may be more accommodating in such situations, making leasing a viable option for those with less-than-ideal credit scores.
- Depreciation Costs: If you wish to avoid bearing the costs associated with asset depreciation, leasing is the way to go. When you lease an asset, you are not responsible for its depreciation because you do not own it. This can save you from potential financial losses that come with the ownership of a depreciating asset, making leasing a more favorable choice.
- Monthly Payment Considerations: Leasing offers an advantage over hire purchases if you prefer lower monthly payments. Lease payments are typically lower because they only cover the asset’s use and not its full purchase price. This can be beneficial for individuals or businesses with budget constraints or those who prefer to allocate their funds to other areas.
- Deposit and Early Termination: If you want to avoid making a substantial upfront deposit or worry about potential early termination fees, leasing provides a more appealing alternative. Lease agreements may only sometimes require a significant deposit or have lower deposit requirements than hire purchase. Additionally, early termination fees are typically associated with hire purchase agreements, while leasing offers more flexibility in returning the asset at the end of the lease term without incurring penalties.
Leasing is preferable when you don’t wish to own the asset, have a poor credit score, want to avoid depreciation costs, prefer lower monthly payments, don’t want to make a significant deposit, and wish to minimize concerns about potential early termination fees.