A finance lease is a lease which transfers substantially all the risks and rewards inherent in the leased asset to the lessee under the lease arrangement. In a finance lease, the lessor derecognizes the underlying asset and recognizes a receivable equal to the net investment in lease.
Accounting literature previously required classification of leases into operating leases and finance leases by both lessees and lessors. However, the new lease accounting standards, IFRS 16 Leases and ASC 842, the US GAAP equivalent, require lessees to capitalize almost all their leases, but still require lessors to classify their leases into finance leases and operating leases.
A finance lease was previously referred to as capital leases in US GAAP.
Finance lease recognition criteria
Risks and rewards inherent in an asset are deemed to be transferred when any of the following conditions are satisfied:
- The ownership of the right of use asset is transferred to the lessee at the end of the lease term;
- The lease allows the lessee to buy the asset at a price so lower than the fair value on the exercise date that it is almost certain (on the inception date) that the lessee will exercise it;
- The lease term represents a major part (at least 70%) of the economic life of the leased asset.
- At inception, the present value of the lease payments is substantially equal (more than 90%) to the fair value of the leased asset; and
- The underlying asset is so specialized that it can only be used by the lessee without significant modifications.
Other indications of a lease being a finance lease include (a) a lessor's ability to claim his losses from the lessee if the lessee cancels the lease, (b) any gain or losses arising from changes in fair value of the residual accruing to the lessee, and/or (c) the lessee having an option to lease the asset for a secondary period at a rent substantially lower than the market rent.
Company C is engaged in the manufacture of bicycles. It has leased some specialized production equipment from Company L. The economic life of the equipment is 6 years and the lease term is 5 years. Total lease payments are $25 million and their present value works out to $20 million. The equipment is specifically designed for the operations of Company C and the lease contract contains a provision which allows Company C to either extend the lease at much lower rates or purchase the equipment at the end of 5 years for $1 million. The fair value of the equipment at the end of the lease term is expected to be $4 million.
This is definitely a finance lease as indicated by the following:
- The lease term represents more than 70% of the economic life of the equipment;
- The lease contains an option to buy the asset at a price ($1 million) substantially lower than fair value ($4 million); and
- The equipment is customized and cannot be used by another party without significant modifications.
- The lease gives the lessee an option to use the lease for a secondary period at lower rent.
A lease need not satisfy all the aforementioned conditions. If any one of the criteria were met, the lease would be accounted for as a finance lease.
Accounting for a finance lease
A lessor recognizes a finance lease by derecognizing the underlying asset and recognizing a lease receivable at net investment in lease.
Net investment in lease equals the present value of lease payments plus initial direct costs (except for manufacturer or dealer leases). The present value is determined using the interest rate implicit in the lease. Subsequently, the net investment in lease is reduced by any lease payments received and increased by recognition of finance income. Finance income is recognized so as to reflect a constant period rate of return.
A manufacturer or dealer lessor shall recognize selling profit or loss on their leases and shall not recognize initial direct costs.
In the example above, the lease shall be recognized using the following journal entry:
|Gross investment in lease||$25 million|
|Property, plant and equipment||$20 million|
|Unearned finance income||$5 million|
Each period, unearned finance income is debited and interest income is credited and lease payments are recorded as reduction in gross investment in lease. In essence, recognition of interest income increases net investment in lease while receipt of lease payments decreases it.