Finance lease

Definitions

Finance lease

For the lessee, a finance lease is one that meets one or more of the following five criteria:

• The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
• The lease grants the lessee an option to purchase the underlying asset, and the lessee is reasonably certain to exercise the option to purchase.
• The lease term is for a major part of the remaining economic life of the asset (commonly 75% or more, per ASC 842-10-55-2 - not a bright-line rule), unless the commencement date of the lease falls at or near the end of the underlying asset’s economic life.
• The present value of the sum of the lease payments and any residual value guaranteed by the lessee not already reflected in the lease payments is equal to or greater than substantially all of the fair value of the underlying asset (commonly 90% or more, per ASC 842-10-55-2 - not a bright-line rule).
• The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

A lease that meets any of the five criteria above is classified as a finance lease; otherwise, it’s classified as an operating lease (covered in the next chapter, Operating lease). This dual classification is a feature of U.S. GAAP (ASC 842). Under IFRS 16, lessees use a single model that accounts for nearly all leases like finance leases - the later chapter on GAAP-IFRS differences covers this contrast further.

Initial recognition

Initial recognition of a lease is the same for finance and operating leases.

In the initial recognition of a lease, you need to determine the value of the lease liability and the ROU asset.

Initial recognition of lease liability

The lease liability is the present value of unpaid lease payments.

Under ASC 842, lessees discount lease payments using the rate implicit in the lease if readily determinable; otherwise, use the incremental borrowing rate (IBR). Implicit rate is rarely known to lessees, defaulting to IBR.

Lease payments include fixed payments, variable payments based on an index or rate (measured at the commencement-date index or rate), the exercise price of a purchase option the lessee is reasonably certain to exercise, termination penalties, and amounts probable of being owed under residual value guarantees. Other variable payments are expensed as incurred.

The process of discounting the lease payments is similar to the concept of a financial instrument at amortized cost discussed in the previous chapter on “investments”.

Initial recognition of ROU asset

The ROU asset is valued at cost, which includes the following:

• The initial value of the lease liability
• Any lease payments already paid at commencement
• Initial direct costs

This total is then reduced by any lease incentives received by the lessee.

Initial recognition journal entry

The lease liability and ROU asset are connected because they are initially booked in a single journal entry, as follows:

Account	Debit	Credit	Financial statement element
ROU asset	XXX		Asset
Lease liability		XXX	Liability
Cash		XXX	Asset
To record initial recognition of a lease

The credit in cash represents the payments of any initial direct costs, lease payments paid in advance net of any lease incentives received.

Subsequent measurement

The ROU asset and lease liabilities initially recognized above should be subsequently measured separately.

Subsequent measurement of ROU asset

Subsequent measurement accounting for ROU assets is different for finance and operating leases.

For finance leases, the ROU asset is amortized over the shorter of the lease term or the asset’s useful life. However, if the lease transfers ownership of the asset to the lessee, or the lessee is reasonably certain to exercise a purchase option, the ROU asset is amortized over the asset’s useful life instead, since the lessee will effectively own and use the asset beyond the lease term. The following entry is recorded to amortize the ROU asset:

Account	Debit	Credit	Financial statement element
Amortization expense	XXX		Expense
ROU asset		XXX	Asset
To record amortization of ROU asset

Subsequent measurement of lease liability

The lease liability is measured the same way for finance and operating leases (effective interest method). Only a finance lease reports the accretion as a separate interest expense; an operating lease includes it in a single lease cost (see the next chapter, Operating lease).

Accordingly, the lease liability is amortized wherein the lease liability is increased by the effective interest expense and decreased by the periodic lease payment. This accounting process effectively splits the periodic lease payment into:

• interest component and
• principal component.

The journal entry to record the effective interest expense:

Account	Debit	Credit	Financial statement element
Interest expense	XXX		Expense
Lease liability		XXX	Liability
To record interest expense on the lease liability

The journal entry to record the lease payment:

Account	Debit	Credit	Financial statement element
Lease liability	XXX		Liability
Cash		XXX	Asset
To record the lease payment

Example: finance lease amortization

A company enters into a finance lease for equipment. The present value of the lease payments at commencement is $\$25,771$, discounted at an incremental borrowing rate of $8\%$. The lease term is $3$ years, with a $\$10,000$ payment due at the end of each year. There’s no purchase option or transfer of ownership, so the ROU asset is amortized on a straight-line basis over the $3$-year lease term.

• Initial recognition: the ROU asset and lease liability are both recorded at $\$25,771$.
• Year 1 interest expense: $\$25,771\times 8\%=\$2,062$
• Year 1 principal reduction: $\$10,000-\$2,062=\$7,938$
• Lease liability balance after the payment: $\$25,771-\$7,938=\$17,833$
• Year 1 ROU amortization: $\$25,771÷3=\$8,590$

Answer: In year 1, the company records $\$2,062$ of interest expense and $\$8,590$ of amortization expense - a combined expense of $\$10,652$, which is more than the $\$10,000$ cash payment.

Variable lease payments

Any variable lease payments not included in the lease liability are recorded as lease expense in the period when they are incurred.

Account	Debit	Credit	Financial statement element
Lease expense - variable lease	XXX		Expense
Cash or lease payable		XXX	Asset or liability
To record variable lease

Financial statement presentation

Finance lease presentation in the balance sheet

In the balance sheet, finance-lease ROU assets are either presented separately from other assets or disclosed in the notes along with the line items that include them. It’s a nonfinancial long-lived asset, not an intangible asset, and finance-lease ROU assets are shown separately from operating-lease ROU assets, though both are reported in a manner similar to property, plant, and equipment.

The lease liability should be split between the current portion and the non-current portion to reflect the timing of the obligations.

Finance lease presentation in the income statement

In the income statement, finance lease accounting results in the recognition of two expense items:

1. Amortization of the ROU asset, and
2. Interest expense from the amortization of the lease liability.

Exam tip: Because interest expense declines over the lease term while amortization stays level, total finance lease expense is front-loaded - higher in the early years and lower later. This differs from an operating lease, which recognizes a single, level lease expense over the term. The next chapter, Operating lease, covers this contrast in detail.

Finance lease presentation in the cash flows

Cash flow classification: principal payments are classified as financing cash flows, interest and variable lease payments as operating cash flows, and initial direct costs are generally treated as investing cash flows (ASC 842 doesn’t explicitly prescribe this; it follows ASC 230’s treatment of costs to acquire a capitalized asset).