Finance Lease Meaning Accounting Calculations With Examples

Finance Lease Meaning

A finance lease means 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 a capital lease) substantially transfers all the risks and rewards of asset ownership 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. Still, all the risks 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; legal ownership of leased assets transfers from the lessor to the 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 fulfills at least one of the following four conditions, then such lease is categorized like a finance lease under US GAAP:

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

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Accounting for Finance Lease

#1 – In the Books of Lessee

At the inception of the lease agreement, Lessee will record the fair value (present value of min lease payments) of the asset on lease at both the asset and liability sides of the balance sheet.
Distribute the payments of periodic lease rentals (paid) into two parts Finance expenses or interest cost (expenses in the income statement) andReduction in outstanding liability.
Journal entry for depreciationJournal Entry For DepreciationDepreciation Journal Entry is the journal entry passed to record the reduction in the value of the fixed assets due to normal wear and tear, normal usage or technological changes, etc. where depreciation account will be debited and the respective fixed asset account will be credited. The main objective of a journal entry for depreciation expense is to abide by the matching principle.read more is passed.

#2 – In the Books of Lessor

Lessor, at the inception of lease record, lease receivable at an amount equal to net investmentNet InvestmentNet investment is calculated as capital expenditure minus non-cash depreciation and amortization for the period, and it indicates how much the company is investing to maintain the life of its assets and achieve future business growth.read more value in lease. The net investment value is calculated by discounting the minimum lease payments at the implicit interest rate.
Distribute the cash received as periodic lease rentals into two parts
Finance or interest income and
Reduction in lease receivable.

Calculation Examples of Finance Lease

Jet Aviation Ltd, an Indian airline company, requires passenger planes. 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%

Finance expenses or interest cost (expenses in the income statement) andReduction in outstanding liability.
Finance or interest income and
Reduction in lease receivable.

The useful life of the plane is six 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 or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period.read more (Boeing) and the lessee (Jet Aviation).

#1 – Examine whether lease meets finance lease criteria

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

#. The lease satisfies most 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:

annual lease rents (P) = $500,000 andImplicit rate of interest (i) = 10%Period (n) = 5 years

#3 – Calculation of Depreciation

PV of plane = $1,895,393Useful life = 6 years

#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.

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

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 andReduction in lease receivable.

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

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

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

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

iii) The entry for depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more is passed.

#6 – Accounting Table Calculation for Finance Lease

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

Advantages

A 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 several 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 AccountProfit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization’s revenue and costs incurred during the financial period and is indicative of the company’s financial performance by showing whether the company made a profit or incurred losses during that period.read more.In general, the finance lease recognizes expenses earlier than the operating lease. Charging interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more also gives a tax benefit.Lessee gets some technical assistance about the asset from the lessor.Even if there is a subsequent rise in the asset’s price, 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 for the 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 asset owner.The lessee controls the asset even though he is not the asset owner 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

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 must 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 in a higher tax bracket would like to classify leases as finance.

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.