Finance lease

Definition

A finance lease, also known as a capital lease, is a type of lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. This arrangement usually leads to the lessee recognizing the asset and liability on their balance sheet, which affects how they report their financial position. Finance leases are classified based on specific criteria that consider the length of the lease term, present value of lease payments, and options to purchase the asset.

5 Must Know Facts For Your Next Test

1. Finance leases often last for most of the asset's useful life, which is one way they differ from operating leases.
2. The lessee typically has the option to purchase the asset at the end of the lease term, often at a bargain price.
3. For accounting purposes, finance leases require the lessee to recognize both an asset and a corresponding liability on their balance sheet.
4. Lease payments for finance leases are made up of both interest and principal repayment components.
5. The classification of a finance lease can impact key financial ratios, such as debt-to-equity and return on assets.

Review Questions

• How does a finance lease differ from an operating lease in terms of risk and reward transfer?
  • A finance lease differs from an operating lease primarily in that it transfers substantially all risks and rewards of ownership to the lessee. In a finance lease, the lessee effectively assumes responsibility for maintaining and utilizing the asset as if they were its owner. In contrast, an operating lease allows the lessor to retain ownership, meaning that risks such as depreciation and obsolescence remain with them.
• Discuss how a finance lease affects both the lessee's balance sheet and income statement compared to other leasing options.
  • When a finance lease is in place, the lessee must recognize both an asset and a corresponding liability on their balance sheet. This contrasts with an operating lease, where only rental expense is recognized. On the income statement, finance leases result in depreciation expense on the leased asset and interest expense on the liability, which can affect profitability measures differently than an operating lease's straightforward rental expense.
• Evaluate how changes in accounting standards regarding finance leases have impacted corporate financial reporting and decision-making.
  • Changes in accounting standards have significantly impacted how companies report finance leases by requiring greater transparency. Previously, many finance leases were kept off-balance-sheet, but new standards mandate that both assets and liabilities related to these leases be included on financial statements. This change has forced companies to reassess their leasing strategies, potentially opting for more operating leases or negotiating terms that provide better financial flexibility as they consider how these leases affect their overall financial health and leverage ratios.

Related terms

operating lease: An operating lease is a type of lease agreement where the lessor retains ownership of the asset, and the lessee only has the right to use it for a specified period without bearing the risks and rewards of ownership.

lease liability: Lease liability is the obligation recognized on the lessee's balance sheet representing future lease payments due under a finance lease.

fair value: Fair value refers to the estimated worth of an asset or liability based on current market conditions, which can be relevant in determining whether a lease qualifies as a finance lease.