Finance Lease

Finance lease refers to the lease where the finance company owns the asset legally during the tenure of the lease but all the risk and reward associated with the asset are transferred to the lessee by the lessor and at the end of the lease term lessee also gets the ownership of the asset.

Finance Lease Meaning

Finance lease simply means a method of providing finance where the leasing company buys the asset for the user and rents it to him for an agreed period. The leasing company is known as the lessor, and the user is known as the lessee. A finance lease (also called capital lease) substantially transfers all the risks and rewards of ownership of the asset to the lessee. It is often used to buy leased assets for a major part of its economic life.

Classification of the Lease as a Finance Lease

The basic criteria to classify a finance lease (also known as a capital lease under US GAAP) is where the lessor remains the legal owner of the asset throughout the lease period, but all the risk and rewards related to leased assets are transferred to the lessee. The, i.e., the lessee records a liability and an asset related to leasing in its balance sheets; Additionally, legal ownership of leased asset transfers from the lessor to lessee after the end of the lease.

However, there is a little contradiction under IFRS and US GAAP in classifying a lease as a finance lease.

IFRS: the above basic criteria classify a lease as a finance lease under IFRS jurisdiction

GAAP: if the lease agreement fulfils at least one of the following four conditions, then such lease is categorized like a finance lease under US GAAP:

  1. The legal ownership of the leased asset transfers from the lessor to the lessee at the end of the lease;
  2. The lessee is allowed to purchase the leased asset at a lower price than the fair value of the leased asset.
  3. The lease term is more than 75% of the leased asset’s useful life.
  4. The present value of lease rentals is equal to or greater than the fair market value of the asset.
Finance-Lease

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Source: Finance Lease (wallstreetmojo.com)

Accounting for Finance Lease

#1 – In the Books of Lessee

  • Lessee, at the inception of the lease agreement, will record the fair value (present value of min lease payments) of the asset on lease at both asset and liability sides of the balance sheet.
Accounting Table for Finance Lease 1
  • Distribute the payments of periodic lease rentals (paid) into two parts
    1. Finance expenses or interest cost (expenses in the income statement) and
    2. Reduction in outstanding liability.
Accounting Table for Finance Lease 1-1
Accounting Table for Finance Lease 1-2

#2 – In the Books of Lessor

Accounting Table for Finance Lease 1-3
  • Distribute the cash received as periodic lease rentals into two parts
    1. Finance or interest income and
    2. Reduction in lease receivable.
Accounting Table for Finance Lease 1-4

Calculation Examples of Finance Lease

Jet Aviation Ltd, an Indian airline company, requires passenger planes for its operations. Jet enters into a legal lease agreement with Boeing (an American based plane manufacturing company) to lease out airplanes. Boeing supplies planes to Jet on January 1, 2019, on a 5-year term against which Jet will pay an annual lease rental of $500,000 at the end of each year. Assume the implicit rate of interest is 10%

The useful life of the plane is 6 years. Jet has the option to buy the planes at the termination of the lease period.

Journalize the necessary accounting in the books of both the lessorLessorA lessor is an individual who legally owns the asset granted on a lease (rented for a long tenure) to the lessee who pays a single lump sum amount or regular payments for using that asset.read more (Boeing) and the lessee (Jet Aviation).

#1 – Examine whether lease meets finance lease criteria

  1. The lease is allowed to purchase the leased asset at the end of the lease period.
  2. The lease term is 83.33% (5/6), which is more than 75% of the leased asset’s useful life.

#. The lease satisfies the majority of the conditions; hence it is classified as a finance lease.

#2 – Calculation of present value (PV) of min finance lease payments

The formula of PV,

PV = P * [1 – (1+i)-n / i]

Given:

  1. annual lease rents (P) = $500,000 and
  2. Implicit rate of interest (i) = 10%
  3. Period (n) = 5 years
Calculation of present value

#3 – Calculation of Depreciation

  1. PV of plane = $1,895,393
  2. Useful life   = 6 years
Calculation of Depreciation

#4 – Accounting in the books of Boeing (Lessor)

i) Record lease receivable against the asset leased out at an amount equal to net investment value in lease.

Accounting in books of Lessor 1

ii) Distribute the cash received as periodic lease rentals into two parts

  1. Finance or interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more and
  2. Reduction in lease receivable.
Accounting in books of Lessor 2

Note: the debited value of lease receivables will reduce the principal amount of $1,895,393 by $450,000. The remaining reduced principal value of $1,445,393 will also reduce the next years’ finance income.

#5 – Accounting in the books of Jet (Lessee)

i) Record the fair value of the asset on lease at both asset and liability sides of the balance sheet.

Accounting in books of Lessee 1

ii) Distribute the payments of periodic lease rentals (paid) into two parts

  1. Finance expenses or interest cost (expenses in the income statement) and
  2. Reduction in outstanding liability.
Accounting in books of Lessee 2

iii) The entry for depreciation is passed.

Accounting in books of Lessee 3

#6 – Accounting Table Calculation for Finance Lease

The table presents the calculation of the finance lease for five years leased period. The table is helpful for the accountant to journalize the annual entry and tally the entered figures.

Accounting Table for Finance Lease

Advantages

  • Finance lease is an important source of medium and long-term financing of assets.
  • Finance lease grants rights to the lessee to use an asset.
  • Lease financing is generally cheaper than all other forms of financing.
  • The finance lease arrangement helps spread the lease payments over a number of years. Hence, there is no burden of a lump-sum payment for asset purchases.
  • The lessee can claim depreciation on the asset leased. This reduces the tax liability of the lessee as depreciation is an expense charged to the Profit and Loss Account.
  • In general, the finance lease recognizes expenses earlier as compared to the operating lease. Charging interest expense also gives a tax benefit.
  • Lessee gets some kind of technical assistance with regard to the asset from the lessor.
  • Even if there is a subsequent rise in the price of the asset, the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more has to pay the fixed payments originally agreed upon.
  • The lessee has the right to purchase the asset at the end of the lease period, generally at a bargain price.

Limitations/Disadvantages

  • The responsibility of maintenance of the asset lies with the lessee. Hence, the lessee has to incur some maintenance expenses.
  • The financial lease involves a substantial transfer of risks to the lessee. Hence, the risks are significantly borne by the lessee.
  • The finance lease is non-cancellable by the lessee. Hence, the lessee is bound by its decision.
  • If the lessee decides not to purchase the asset, he will not become the owner of the asset.
  • The lessee controls the asset even though he is not the owner of the asset during the finance lease. Since he is not the owner, he may not exercise due care of the asset.
  • Entering into a finance lease involves a lot of documentation and other formalities.

Important Points to Note about

  • After every period when the lease payment is made, there is a reduction in the balance payment to be made as given in the amortization schedule.
  • Finance leases impact the lessee’s financial statements. They influence assets, liabilities, interest, and depreciation.

Final Thoughts

Lease finance is an appropriate mode of finance for those who cannot raise funds through debt. The finance lease grants the right to use the asset. Both finance lease and capital leaseCapital LeaseA capital lease is a legal agreement of any business equipment or property equivalent or sale of an asset by one party (lesser) to another (lessee). The lesser agrees to transfer the ownership rights to the lessee once the lease period is completed, and it is generally non-cancellable and long-term in nature.read more have their own merits and demerits. A company has to carefully decide whether it wants to enter finance lease agreements after considering them. This is all the more important as a finance lease involves a substantial transfer of risks to the lessee. Generally, firms that are in a higher tax bracket would like to classify leases as a finance lease.

This has been a guide to the meaning of Finance Lease. Here we discuss accounting for finance lease calculation examples along with journal entries. You can learn more about accounting from the following articles –