Finance lease
Encyclopedia
A finance lease or capital lease is a type of lease
. It is a commercial arrangement where:
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.
Following the GAAP
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 sheet
. See Statement of Financial Accounting Standards No. 13 (FAS 13) for more details of classification and accounting.
(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.
, 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:
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.
Lease
A lease is a contractual arrangement calling for the lessee to pay the lessor for use of an asset. A rental agreement is a lease in which the asset is tangible property...
. It is a commercial arrangement where:
- the lessee (customer or borrower) will select an assetAssetIn financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
(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 interestInterestInterest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
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.
Treatment in the United States
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 valuePresent valuePresent value, also known as present discounted 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 GAAP
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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 sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. 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 CodeUniform Commercial Code
The 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.The goal of harmonizing state law is...
(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
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....
, 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
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
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 capitalWorking capitalWorking capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...
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 (ROEReturn on equityReturn on equity measures the rate of return on the ownership interest of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity . ROE shows how well a company uses investment funds to generate earnings growth...
and ROA) are overstated.
See also
- LeaseLeaseA lease is a contractual arrangement calling for the lessee to pay the lessor for use of an asset. A rental agreement is a lease in which the asset is tangible property...
- LeasingLeasingLeasing 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....
- Operating lease
- Leveraged leaseLeveraged leaseA 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 StatesAccounting for leases in the United StatesAccounting for leases in the United States regulated by the Financial Accounting Standards Board by the Financial Accounting Standards Number 13. These standards were effective as of January 1, 1977...