Asset Management tends to be one of the most important tasks of a managerial accountant. In this regard, it is important for the managerial accountant to ensure that they are able to 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. When it comes to asset financing, financial lease and hire purchase are considered to be the top choices for companies because of the relative advantages they offer in comparison to traditional financing tools.
What is Financial Lease?
A financial lease can be simply be defined as a contract between the customers and the equipment suppliers for using a particular asset over a period of time against periodic payments, referred to as lease payments. All lease contracts involve a lessee (the user of the asset), as well as 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 is going to be periodically reduced as subsequent lease payments are taken into account.
A financial lease also referred to as a capital lease is a contract that is formed between two parties, one of which wants to use the asset, and the other party, that has the ownership of the asset. There are certain criteria that need to be fulfilled in order for a lease to be classified as a financial lease. These criteria is summarized below:
- Ownership of the asset is transferred to the lessee at the end of the lease contract.
- A bargain purchase option that gives the option to the lessee to procure the asset at a discounted price at the end of the term.
- The term of the lease should be greater than or equal to 75% of the useful life of the asset.
- The present value of the lease payments should be greater than or equal to 90% of the asset’s fair market value.
Therefore, financial lease is considered to be long-term, since it spans over a considerable majority chunk of the useful life of the asset. It is considered to be a top choice for organizations because it allows them to use the asset without having to pay a hefty amount in line of procuring the asset.
What is Hire Purchase?
A Hire Purchase is referred to as an arrangement that involves purchasing assets of a considerable amount. In other words, hire purchase is considered to be a type of asset finance that allows firms or individuals to possess and control an asset during an agreed term. However, the user of the asset 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 user of the asset cannot capitalize it in the financial statements, and would only do so once the payments have been transferred.
Hire Purchase is considered as a financing solution that is suitable for businesses that want to purchase assets in the longer run, without having to pay the full cost of the asset in an upfront manner. This might either be because of the lack of liquid resources, or it might be 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 a period of 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 transfer of ownership can only take place 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 in comparison to typical leasing contracts. The fundamental difference between a financial lease and a hire purchase tends to be the fact that in the financial lease, there is no necessary intent of purchasing the asset at the end of the contract. However, in the case of hire purchase, the organization normally does end up purchasing the asset.
The key differences between financial lease and hire purchase has been summarized has been summarized in the table below:
|Financial Lease||Hire Purchase|
|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 in 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. Prior to the installments being paid, the organization that has procured the asset cannot possibly record it as an asset in their own financial statements.|
|Depreciation is claimed as an expense in the books of the lessor, unless it’s a financial lease.||Depreciation of the asset is allowed to the individual contracting the hire purchase. This is because technically the asset is going to be transferred to the organization that is using the asset. Hence, it makes sense for them to depreciate it in their own 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 that is charged on the hire purchase is a flat rate.|
|Financial Lease spans over a longer time duration. The cost of the asset is considerably high. Therefore, it spreads over a considerably significant period of time.||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 of time.|
|In case of the operating lease, the responsibility of maintaining the asset lies with the lessor. If a financial lease is drawn, only then the responsibility of the ownership lies 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 otherwise 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.|