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, 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.
• 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

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 discounted at an appropriate discount rate which can either be the:

• implicit rate of the lease or
• the incremental borrowing rate.

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.

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 subsequent measurement of lease liability is the same for both finance and operating leases.

It also follows the same amortization concept for financial instruments at amortized cost discussed in the previous chapter about “investments”.

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. Interest expense declines each year as the liability is paid down, while amortization stays level, which is why finance leases produce a front-loaded expense pattern.

Variable lease payments

Any variable lease payments not included in the lease liability is 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, the ROU asset is presented as its own noncurrent asset line. 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: the portion of the lease payment applied to the principal of the lease liability is classified as a financing cash flow, while the interest portion and any variable lease payments are classified as operating cash flows. Cash payments for initial direct costs incurred by the lessee are classified as investing activities, since they represent costs to acquire the ROU asset, similar to other capital expenditures.