A finance lease is a method of financing assets where they remain the property of the finance company that hires them and the lessee pays for the hire of the asset or assets.
The lessor charges a rent as their reward for hiring the asset to the lessee. The lessor retains ownership of the asset but the lessee gets exclusive use of the asset (subject to meeting the terms of the lease).
A finance lease transfers substantially all of the risks and rewards of ownership of the asset to the lessee. Using a finance lease means that the asset will appear on the lessee’s balance sheet, with outstanding rentals represented as a liability.
Finance leases are either fully amortising (the rentals write the asset down to zero at the end of the term of hire) or to a balloon rental (this may equal the estimated value of the asset at the end of the term of hire).
The balloon rental is a contracted sum that the lessee pays at the end of the term of hire but, of course, the lessee has had the benefit of paying a lower rental during the term itself. Leases with balloon rentals are usually available where the asset has an intrinsic value which will be at least equal to the balloon rental.
At the end of the lease term, the lessee may be offered a lease on the asset for a secondary period at anything between a nominal ‘peppercorn’ rental and a commercial rent.