Finance Lease: What is it? And How Does It Work?

What is a Finance Lease?

Leasing of business assets has become a fairly common practice in the modern-day and age. In this regard, it is rudimentary to realize the fact that there are two broad categories of leases that are normally used in today’s business dynamic. They are referred to as operating lease and finance lease. Both these lease types have different functionalities, and therefore, they are utilized in different capacities depending on the underlying requirement of the company.

The process of leasing undertakes a certain amount of risk. This risk can be reduced, but cannot be eliminated altogether. A finance lease is considered to be a lease, where all risks and rewards that exist pertaining to the ownership of the asset are simply transferred to the lessee. In other words, the lessee tends to be the owner of the asset, and therefore, all the risks that might be associated with the ownership of the particular asset, are supposed to be solely born by the lessee.

What are Finance Lease indicators?

In order to determine the type of lease that is applicable to a certain cause, it can be seen that it is important to take note of the conditions that are mentioned in the lease agreement, and in particular, the clauses of the lease itself. These indicators, which help in the determination of the lease contract mainly lie in the realms of risks and rewards that are associated with the process. Subsequent explanation of these lease indicators is given below:

  • Economic Life: As far as economic life is concerned, a financial lease extends over a period such that it covers most or almost all of the economic life of the asset. For example, if an asset has a life of 10 years, then a financial lease agreement, if drawn, would be equivalent to a tenure of greater than or equal to 7.5 years.
  • Maintenance Costs: During the time of the financial lease, the lessee tends to be solely responsible for all the repairs and maintenance costs that may arise as a result of holding and maintaining the asset.
  • Capitalization: Regardless of the fact that the organization that has leased the asset (i.e. the lessee) has not paid an upfront amount in lieu of purchasing the asset, yet the asset is supposed to be capitalized in his books. This implies that all assets and liabilities should be recorded in the books of the lessee as if the asset was actually procured by the lessee in this aspect.
  • Lease Payments: At the time of the inception of the lease, it is important that the present value of the lease payments should amount to the fair value of the asset involved.
  • The lease agreement should, by default, transfer the ownership of the asset to the lessee at the end of the lease.
  • The leased asset should be of a specialized nature.
  • The lessee should have an option to purchase the asset at a price that is expected to be lower than the existing fair value at the date when the option becomes exercisable.
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How does a Finance Lease work?

As mentioned earlier, it can be seen that a finance lease tends to be treated quite differently from an accounting perspective as compared to other lease types. Finance lease spreads over a considerable time span, and therefore, it has to be reflected in the same manner in the financial statements.

Financial Lease can be defined as a way of financing the assets where they tend to remain the property of the lessor unless all lease payments have been accounted for. In exchange for the lease that is undertaken, the lessor charges a reward for hiring the particular asset to the lessee. A finance lease, as mentioned earlier, substantially transfers the risks and the rewards that are associated with the ownership of the lessee to the lessor. In the case where a finance lease is used, it can be seen that the asset tends to appear on the Balance Sheet of the company, with outstanding rentals being treated as a liability.

Finance leases can either be fully amortizing or based on a balloon rental. In the case where finance leases are fully amortizing, it can be seen that the rentals write the assets down to zero at the end of the term of hire. In the case of balloon rentals, these rentals are normally equivalent to the estimated value of the asset at the end of the lease tenure. In other words, balloon rental is a contracted sum that the lessee pays at the end of the lease tenure. However, during the lease period, the lessee ends up paying a lesser amount in rents as compared to a fully amortized lease arrangement.

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At the end of the tenure of the finance lease, the lessee and the lessor might extend the lease, or have a bargain purchase option. This is purely contingent on the terms of the lease agreement that has been signed upon by both parties. In the case where the extension is not sought, then the lessor might either sell the asset to the lessee, or to another party interesting in purchasing the asset.

During the term of the lease, if the lessee no longer needs the asset, or needs a different asset, then the lessee also has the option to sublet the asset, and extend the lease to a third party. However, this also depends on the terms and the clauses that are mentioned in the lease agreement, and this is something that might not necessarily be true for all types of financial leases.

Accounting for Financial Lease

In order to account for Financial Lease, there are a couple of steps that need to be taken into account. As far as the initial accounting is concerned, it can be seen that the lessee is supposed to capitalize the finance leased asset in their own financial statements.

In the same manner, they need to set up a lease liability amount that is equivalent to the value of the asset that is recognized. In order to do this, the following journal entry is carried out:

Dr. Non-Current Assets

Cr. Finance Lease Liability

Following this initial record keeping, it is important to account for other fixed asset-related outcomes, just like they are recorded for in the case where the company procures an asset by paying for it in an upfront manner. These descriptions are given below:

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After the initial capitalization, the company needs to record depreciation every subsequent year. Depreciation is charged on the asset depending on the shorter the useful life of the asset, or the lease period mentioned in the lease agreement. The journal entry for this is given below:

Dr. Depreciation Expenses

Cr. Accumulated Depreciation

Lease Rental/Interest

In order to record the payment of lease rentals during every subsequent lease period, the following journal entry is made:

Dr. Finance Lease Liability

Cr. Bank

These transactions are made on a continual basis across the course of the lease term. At the end of the lease term, the amount of Finance Lease Liability is reduced to zero, whereas the relevant credit entries have already been made by paying off the dues via bank. Finance Lease mostly does require asset capitalization, because in almost all Finance Lease cases, the lessee ends up purchasing the asset from the lessor.

Therefore, it makes sense for the lessee to capitalize these expenses earlier on in the Balance Sheet (as a Non-Current Asset), equivalent to the present value of the lease payments that need to be made in order to fulfill the lease contract.