What is Finance Lease?
The term “finance lease” refers to the mutual contract according to which the lessor transfers the ownership of the asset to the lessee before the expiry of the lease agreement. In other words, in a finance lease, the lessee is transferred all the risks and rewards associated with the leased asset before the expiry of the lease agreement.
It is predominantly used for the purchase of equipment. Further, not all leases qualify as a finance lease as there are certain requirements that should be met in order to be considered as a finance lease. The conditions are as follows:
- The lessee will have the option to purchase the asset at a bargain price after the expiry of the lease agreement.
- The duration of the lease covers at least 75% of the useful life of the asset.
- The present value of the future lease payments should add up to a minimum of 90% of the asset’s value.
Features of Finance Lease
The features are as follows:
- The lessee picks the required asset, usually equipment, vehicles, software, etc.
- The lessor funds the purchases of the asset and leases it to the lessee.
- The lessee utilizes the asset during the course of the lease, during which the lessee pays series of installments to the lessor for the asset.
- At the expiry of the lease, the lessee is offered the option to acquire ownership of the asset by paying a bullet payment, which is usually a bargain price.
Examples of Finance Lease
Following are the example are given below:
Let us take the example of ASD Inc. that has leased some specialized production equipment from DFG Inc. The estimated useful life of the machinery is 5 years, and the lease term is 3 years. As per the current market, the fair value of the machinery is $10 million, while the present value of lease payments is $7 million. Determine if the lease agreement qualifies as a finance lease.
As per the given information,
- The lease tenor is 60% (= 3 years / 5 years) of the equipment’s useful life, which is less than the threshold of 75%.
- The present value of the lease payments is 70% (= $7 million / $10 million) of the asset value, which is also less than the threshold of 90%.
- Since 2 out of the 3 three are not satisfied, the lease doesn’t qualify as a finance lease.
Let us take the example of another company ERT Inc. that has leased heavy earth moving machinery (HEMM) from GHJ Inc. As per the lease agreement; the lessee will pay an annual lease rental of $50,000 at the end of each year of the 5-year lease term.ERT Inc. has the option to purchase the HEMM at a bargain price after the expiry of the lease period. Determine if the lease agreement qualifies as a finance lease if the applicable interest rate is 8%, the useful life of the asset is 6 years, and the asset value is $215,000.
As per the given information,
- The lease tenor is 83.3% (= 5 years / 6 years) of the equipment’s useful life, which is more than the threshold of 75%.
- The present value (PV) of the lease payments is 92.9% (= $199,636 / $215,000) of the asset value, which is more than the threshold of 90%. The calculation of PV is shown below.
PV = $50,000 * [1 – (1 + 8%)-5] / 8%
PV = $199,636
- The lessee has the option to purchase the asset at a bargain price after the expiry of the lease period. Therefore, the lease agreement satisfies all the conditions, and hence it qualifies as a finance lease.
Accounting of finance lease in the lessor’s books is done as follows:
- Record the leased asset in the books with a value equal to the net investment.
- Estimate the unguaranteed residual value for computing the lessor’s gross investment.
- Revise the income allocation over the remaining lease term in case of any reduction in the estimated unguaranteed residual value.
- Any direct cost owing to the lease can either be immediately recorded in the income statement or spread across the lease tenor.
Accounting of finance lease in the lessee’s books is done as follows:
- Recordassetand liability of value equal to the fair value of the asset at the start of the lease.
- Divide the lease rental payments into a reduction of outstanding liability and payment of finance charges.
- Pass the depreciation expense of the leased asset through the income statement.
Impact of Finance Lease
Some of the impacts of the financial lease are as follows:
- Since finance leased asset is capitalized, it results in an increase of assets as well as liabilities.
- The debt-equity ratio goes up due to an increase in outside liabilities leading to additional leverage.
- In the cash flow statement, it impacts both operating and financial cash flow because the principal part of the lease payments is recorded under operating cash flow, and the interest portion is recorded under financing cash flow.
Finance Lease vs Operating Lease
Some of the main differences between a finance lease and an operating lease are:
- In a finance lease, ownership of the asset is transferred to the lessee after the expiry of the lease term. But, in the operating lease agreement, the ownership of the asset always stays with the lessor.
- It may have the option of balloon/residual payment so that the lessee can buy the asset. But, in an operating lease, such an option is not there.
- Finance lease assets form part of the balance sheet and income statement. But operating lease assets are treated as off-balance sheet items and appear only in the income statement.
Some of the major advantages are as follows:
- The asset can be purchased through periodic installments rather than a large upfront investment.
- The lease rentals are spread across the lease tenor, and the fixed payments usually don’t change due to change in bank interest rates.
- There are options of flexible repayment structures under finance lease contracts.
Some of the major disadvantages are as follows:
- Failure to repay can result in repossession of the asset by the lessor.
- The assets are not protected against bankruptcy.
So, by now, you must have understood which type of lease is known as a finance lease, what is its accounting treatment and what are the associated advantages and disadvantages.
This is a guide to Finance Lease. Here we also discuss the introduction and accounting treatment of finance lease along with advantages and disadvantages. You may also have a look at the following articles to learn more –