A
finance lease or capital lease is a type of
leaseA lease is a contract conferring a right on one person to possess property belonging to another person to the exclusion of the owner landlord, and all others except with the invitation of the tenant. It is a rental agreement between landlord and tenant...
. It is a commercial arrangement where:
- the lessee (customer or borrower) will select an asset
In business and accounting, assets are economic resources owned by business or company. Anything tangible or intangible that one possesses, usually considered as applicable to the payment of one's debts is considered an asset. Simplistically stated, assets are things of value that can be readily...
(equipment, vehicle, software);
- the lessor (finance company) will purchase that asset;
- the lessee will have use of that asset during the lease;
- the lessee will pay a series of rentals or installments for the use of that asset;
- the lessor will recover a large part or all of the cost of the asset plus earn interest
Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in...
from the rentals paid by the lessee;
- the lessee has the option to acquire ownership of the asset (e.g.
A
finance lease or capital lease is a type of
leaseA lease is a contract conferring a right on one person to possess property belonging to another person to the exclusion of the owner landlord, and all others except with the invitation of the tenant. It is a rental agreement between landlord and tenant...
. It is a commercial arrangement where:
- the lessee (customer or borrower) will select an asset
In business and accounting, assets are economic resources owned by business or company. Anything tangible or intangible that one possesses, usually considered as applicable to the payment of one's debts is considered an asset. Simplistically stated, assets are things of value that can be readily...
(equipment, vehicle, software);
- the lessor (finance company) will purchase that asset;
- the lessee will have use of that asset during the lease;
- the lessee will pay a series of rentals or installments for the use of that asset;
- the lessor will recover a large part or all of the cost of the asset plus earn interest
Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in...
from the rentals paid by the lessee;
- the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option purchase price);
The finance company is the legal owner of the asset during duration of the lease.
However the lessee has control over the asset providing them the benefits and risks of (economic) ownership.
Comparison with operating lease
A finance lease differs from an operating lease in that:
- in a finance lease the lessee has use of the asset over most of its economic life and beyond (generally by making small 'peppercorn
The original meaning of Peppercorn is the fruit of Black pepper.It may also refer to:* Peppercorn , a very small payment used to satisfy the requirements for the creation of a legal contractOther plants:*Peppercorn tree*Sichuan peppercorn...
' payments at the end of the lease term).
In an operating lease the lessee only uses the asset for some of the asset's life.
- in a finance lease the lessor will recover all or most of the cost of the equipment from the rentals paid by the lessee.
In an operating lease the lessor will have a substantial investment or
residual valueResidual value is one of the constituents of a leasing calculus or operation. It describes the future value of a good in terms of percentage of depreciation of its initial value....
on completion of the lease.
- in a finance lease the lessee has the benefits and risks of economic ownership of the asset (e.g. risk of obsolescence, paying for maintenance, claiming capital allowances/depreciation
Depreciation is a term used in accounting, economics and finance to spread the cost of an asset over the span of several years.In simple words we can say that depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or...
).
In an operating lease the lessor has the benefits and risks of owning the asset.
The U.S.
Financial Accounting Standards BoardThe Financial Accounting Standards Board is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles within the United States in the public's interest. The Securities and Exchange Commission designated the FASB as the organization...
and the
International Accounting Standards BoardThe International Accounting Standards Board founded on April 1, 2001 is the successor of the International Accounting Standards Committee founded in June 1973 in London...
announced in 2006 a joint project to comprehensively review lease accounting standards. In July 2008, the boards decided to defer any changes to lessor accounting, while continuing with the project for lessee accounting, with the stated intention to recognize an asset and obligation for all lessee leases (in essence, making all leases finance leases). The projected completion of the project is now 2011.
Treatment in the United StatesAccounting for leases in the United States is regulated by the Financial Accounting Standards Board .-Accounting for leases by the lessee:...
Under US accounting standards, a finance (capital) lease is a lease which meets at least one of the following criteria:
- ownership of the asset is transferred to the lessee at the end of the lease term;
- the lease contains a bargain purchase option to buy the equipment at less than fair market value;
- the lease term equals or exceeds 75% of the asset's estimated useful life;
- the present value
Present value is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of the lease payments equals or exceeds 90% of the total original cost of the equipment.
Following the
GAAPIn demonology, Gaap is a mighty Prince and Great President of Hell, commanding sixty-six legions of demons. He is, according to The Lesser Key of Solomon, the king and prince of the southern region of Hell and Earth, and according to the Pseudomonarchia Daemonum the king of the western region and...
accounting point of view, such a lease is classified as essentially equivalent to a
purchase by the lessee and is capitalized on the lessee's
balance sheetIn financial accounting, a balance sheet or statement of financial position is a summary of a person's or organization's balances. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a snapshot of a...
. See
Statement of Financial Accounting Standards No. 13 (FAS 13) for more details of classification and accounting.
Special Case: Finance Leases under UCC Article 2A
The term sometimes means a special case of lease defined by Article 2A of the
Uniform Commercial CodeThe Uniform Commercial Code , first published in 1952, is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America...
(specifically, Sec. 2A-103(1) (g)). Such a finance lease recognizes that some lessors are financial institutions or other business organizations that lease the goods in question purely as a financial accommodation and do not want to have the warranty and other entanglements that are usually associated with leases by companies that are manufacturers or merchants of such goods. Under a UCC 2A finance lease, the lessee pays the payments to the lessor (and indeed must do so, regardless of any defect in the leased goods – this obligation usually being contained in a "hell or high water" clause), but any claims related to defects in the leased goods may be brought only against the actual supplier of the goods. UCC 2A finance leases are usually easy to identify because they commonly contain a clause specifically declaring that the lease is to be considered a finance lease under UCC 2A.
International Financial Reporting Standards
In the over 100 countries that govern accounting using
International Financial Reporting StandardsInternational Financial Reporting Standards are Standards, Interpretations and the Framework for the Preparation and Presentation of Financial Statements adopted by the International Accounting Standards Board .Many of the standards forming part of IFRS are known by the older name of...
, the controlling standard is IAS 17, "Leases". While similar in many respects to FAS 13, IAS 17 avoids the "bright line" tests (specifying an exact percentage as a limit) on the lease term and present value of the rents. Instead, IAS 17 has the following five tests. If any of these tests are met, the lease is considered a finance lease:
- ownership of the asset is transferred to the lessee at the end of the lease term;
- the lease contains a bargain purchase option to buy the equipment at less than fair market value;
- the lease term is for the major part of the economic life of the asset even if title is not transferred;
- at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
- the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.
Treatment in Australia
In
AustraliaAustralia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the continental mainland , the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans...
the accounting standard pertaining to lease is AASB 117 'Leases'. AASB 117 was released in July 2004. AASB 117 'Leases' applies to accounting for leases other than: (a) leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources; and (b) licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.
According to AASB 117, paragraph 4, a lease is: an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.
A lease is classified as a finance lease if it "transfers substantially all the risks and rewards incidental to ownership of an asset." (AASB 117, p8) There are no strict guidelines as to what constitutes a finance lease, however guidelines are provided within the standard.
Impact on accounting
- Since a finance lease is capitalized, both assets and liabilities (current and long-term ones) in the balance sheet increase. As a consequence, working capital
Working capital, also known as net working capital or NWC, is a financial metric which represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus...
decreases, but the debt/equity ratio increases, creating additional leverage.
- Finance lease expenses are allocated between interest expense and principal value much like a bond or loan; therefore, in a statement of cash flows, part of the lease payments are reported under operating cash flow but part under financing cash flow. Therefore, operating cash flow increases.
- Under operating lease conditions, lease obligations are not recognized; therefore, leverage ratios are understated and ratios of return (ROE
Return on Equity measures the rate of return on the ownership interest of the common stock owners...
and ROAThe return on assets percentage shows how profitable a company's assets are in generating revenue.ROA can be computed as:This number tells you what the company can do with what it has, i.e. how many dollars of earnings they derive from each dollar of assets they control. Its a useful number for...
) are overstated.
See also
- Leasing
Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets...
- Operating lease
- Leveraged lease
A leveraged lease is a lease in which the lessor puts up some of the money required to purchase the asset and borrows the rest from a lender. The lender is given a senior secured interest on the asset and an assignment of the lease and lease payments...
- Accounting for leases in the United States
Accounting for leases in the United States is regulated by the Financial Accounting Standards Board .-Accounting for leases by the lessee:...
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