What happens at the end of a finance lease?

It depends on the contract. The business may pay the residual and then be able to acquire the asset, may sell the asset on the financier's behalf and settle the difference against the residual, or may continue at a low secondary rent. Tax rules in each country can shape which of these is allowed. The business should plan for the residual as a dated obligation, because the asset's market on that day decides whether a sale covers it.

Can a finance lease be ended early?

Usually only by paying it out. The contract normally sets a termination sum, commonly built from the remaining payments and the residual with some allowance for interest not yet earned, and credit for the asset's sale depends on the terms. The payout can exceed what the asset would fetch. That matters when a business is sold or refinanced, because a buyer or new lender will treat the termination sum as debt to be settled or carried.

Does a finance lease count as debt in a loan covenant?

Often, but the definition decides. Many facility agreements include finance leases in borrowings. Since IFRS 16, and under FRS 102 from 2026, operating leases also appear as liabilities in a lessee's accounts, so agreements either freeze the earlier treatment or state which leases are in. A covenant figure can therefore differ from the balance sheet in either direction. Outside the covenant, a lender's own reading usually counts the payments as fixed commitments beside debt service.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Finance Lease: a Worked Example

The financier keeps the title. The business keeps the risk.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

When a business says an asset is leased, a lender's first question is who takes the loss if it sells for less than expected at the end. Under a finance lease that is the business, even though a financier holds legal title. The payments recover most of the cost with interest, and the sum left over is paid or made good by the business. A lender therefore adds the outstanding balance to debt and the payments to debt service. Whether the accounts show it the same way depends on the reporting framework.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// MAKE THE CALL

Issue 11 — The Term Sheet War. A nine-year client brings a competitor's term sheet: 40 basis points inside your pricing, covenant-lite, and a Friday deadline. Your call first, then the senior banker's.

Read the file →

PART OF Corporate Lending and Credit Risk

// 01 — WHY A LENDER READS IT AS BORROWING

A business that signs a finance lease picks the asset, and a financier buys it and owns it for the term. The business insures and maintains it and commits to a schedule that recovers most of the cost with interest. It generally cannot walk away without paying out the balance. The financier earns its return from that schedule and from the sum fixed for the end of the term, so it has little use for the machine itself.

To a bank lending to the same business, that is a second creditor with a fixed claim and first call on an asset the business uses every day. If the payments stop, the asset goes, and the earnings that service the bank's loan can go with it.

The accounting label now does less work than it did. A finance lease is one that transfers substantially all the risks and rewards of ownership, judged on substance rather than form. Under IFRS 16, as adopted in New Zealand and Australia, the lessor applies that test; the lessee puts most leases on its balance sheet either way. FRS 102 in the UK removed the distinction for lessees in periods beginning on or after 1 January 2026. UK micro-entities on FRS 105, and smaller New Zealand and Australian companies preparing special-purpose accounts, may show something else, so a lender reads the contract as well as the accounts.

// 02 — HOW THE PAYMENTS ARE BUILT

Payment = (Cost − Residual ÷ (1 + i)^n) × i ÷ (1 − (1 + i)^−n)

Balance after each payment = balance × (1 + i) − payment

i = rate per period n = number of payments

The arithmetic is a loan's, with part of the principal left to the end. The residual is a contract figure, and its size moves every payment: a higher residual lowers the instalments and raises what is outstanding on the last day. What happens then varies with the contract and its tax treatment. The business may have to pay the residual itself. It may instead sell the asset for the financier and make good any shortfall, commonly keeping most of a surplus. Some contracts allow a secondary period at a low rent.

// 03 — THE EXAMPLE

A water-well drilling contractor, constructed for this page like every figure in it, needs a US$1.5m rig. It takes a five-year finance lease at an implicit rate of 8%, with monthly payments in arrears and a US$300,000 residual it guarantees. Net bank debt is US$5.0m and bank debt service US$1.0m a year. EBITDA is US$3.0m and cash available for debt service US$1.9m, both including the rig's expected contribution and both before any lease payment. These levels are the example's and not a market norm.

i = 8% ÷ 12 n = 60

Monthly payment = (1,500,000 − 300,000 ÷ (1 + i)^60)

× i ÷ (1 − (1 + i)^−60) = 26,332

Annual payments = 315,980

Balance: start 1,500,000 · year 1 1,296,672

year 3 837,987 · year 5 300,000

Finance charges over the term = 379,900

Net debt ÷ EBITDA, lease unread: 5.0 ÷ 3.0 = 1.67×

With the lease at the start: (5.0 + 1.5) ÷ 3.0 = 2.17×

Cover, lease unread: 1.9 ÷ 1.0 = 1.90×

With the payments: 1.9 ÷ 1.316 = 1.44×

The lease adds half a turn of leverage and takes more than 0.4 off cover, on an asset the bank has no first claim to. The end of the term shows why it is not a rental:

Rig sells for Finance lease Operating lease

420,000 surplus of 120,000* financier's gain

300,000 nothing either way nothing either way

180,000 pays 120,000 financier's loss

* where the contract passes the surplus to the lessee

The accounts may not show the whole of this. IFRS 16 measures the liability using the amounts expected to be payable under a residual guarantee, so a contractor that expects the rig to fetch at least US$300,000 would book about US$1.30m at the start, while the financier's balance is US$1.5m. A lender asks for the financier's schedule and uses the balance.

// 04 — HOW IT DIFFERS FROM ITS NEIGHBOURS

Four structures can put the same rig in the same yard. Under an operating lease or rental, the financier keeps the asset and its end value. Under a finance lease, the title stays with the financier and the end value sits with the business. Hire purchase carries title across at the last payment. An equipment loan, which Australian financiers often call a chattel mortgage, a name also heard in New Zealand, gives the business title from the start, with security back to the lender. Names vary between countries and financiers, so a desk works from the schedule and the end-of-term clause.

DEFINED IN ONE PARAGRAPH → · EQUIPMENT LOAN VS LEASE → · THE PRODUCT FILE →

// 05 — WHERE IT DECIDES A FILE

The first place is the facility agreement. Many agreements count finance leases as borrowings and limit new ones through a permitted-debt basket, so a lease the bank has not been told about can be a breach. Since IFRS 16 the drafting often has to say which leases count, commonly by freezing the earlier accounting so that ordinary property leases stay outside the debt definition.

The second is security. Under the personal property securities regimes, a lease of goods by a lessor in that business can be a security interest whoever holds title: in New Zealand for a term of more than one year, in Australia for more than two. A lessor that registers in time can rank ahead of a bank's general security over that asset, and one that does not can lose out to it, so the lender searches the register. The UK has no general register of this kind for leased goods, and the lessor relies on its ownership.

The third is the calendar. A contractor with several leases has several residuals, and they can fall due together. A desk lists them by year beside a realistic resale figure and asks where the cash comes from if the sale falls short.

LEASE-ADJUSTED LEVERAGE, WORKED → · FIXED CHARGE COVER →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Australian Accounting Standards Board, AASB 16 Leases (compiled to 31 December 2023), the Australian text of IFRS 16 — paragraphs 22, 27(c) and 61–63 — A lessee recognises a right-of-use asset and lease liability, the liability includes amounts expected to be payable under a residual guarantee, and the lessor classifies on substance by whether substantially all risks and rewards transfer — sections 01 and 03.
Financial Reporting Council (UK), FRS 102 Explainer: a summary of the Periodic Review 2024 changes for financial statements users, June 2026 — The distinction between operating and finance leases is removed for lessees in periods beginning on or after 1 January 2026, and covenant compliance may be affected — sections 01 and 05.
Personal Property Securities Amendment (PPS Leases) Act 2017 (Australia), Schedule 1 — Raises the term in the definition of a PPS lease in section 13 of the Personal Property Securities Act 2009 from one year to two — section 05.

// QUESTIONS PEOPLE ASK

What is the difference between a finance lease and an operating lease?: The difference is who bears the asset's value. Under a finance lease the payments recover most of the cost and the business stands behind the amount left at the end, so a fall in resale value is its loss. Under an operating lease the payments cover a period of use, and the financier takes the asset back with whatever value remains. Lessor accounting draws the line by asking whether substantially all the risks and rewards of ownership have passed. A lender draws it by reading the end-of-term clause.
What happens at the end of a finance lease?: It depends on the contract. The business may pay the residual and then be able to acquire the asset, may sell the asset on the financier's behalf and settle the difference against the residual, or may continue at a low secondary rent. Tax rules in each country can shape which of these is allowed. The business should plan for the residual as a dated obligation, because the asset's market on that day decides whether a sale covers it.
Can a finance lease be ended early?: Usually only by paying it out. The contract normally sets a termination sum, commonly built from the remaining payments and the residual with some allowance for interest not yet earned, and credit for the asset's sale depends on the terms. The payout can exceed what the asset would fetch. That matters when a business is sold or refinanced, because a buyer or new lender will treat the termination sum as debt to be settled or carried.
Does a finance lease count as debt in a loan covenant?: Often, but the definition decides. Many facility agreements include finance leases in borrowings. Since IFRS 16, and under FRS 102 from 2026, operating leases also appear as liabilities in a lessee's accounts, so agreements either freeze the earlier treatment or state which leases are in. A covenant figure can therefore differ from the balance sheet in either direction. Outside the covenant, a lender's own reading usually counts the payments as fixed commitments beside debt service.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Business relationship managerCarries a book of trading businesses — wins them, keeps them, and is the bank's voice when the answer is no.
Credit analystReads a borrower and writes the recommendation a decision-maker will act on.
Lending operations officerTurns an approval into a working facility — documentation, security, drawdown, and the register that says what the bank actually holds.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE NUMBER · THE LOAN · CAPACITY

A US$2m machine is expected to save US$400k of cash a year. The borrower asks for a three-year loan to buy it.

How long does the machine take to pay for itself?

5 MORE ON THE LOAN · CAPACITY →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHFinance lease What is the difference between a finance lease and an operating lease?