A Finance Lease, also known as capital lease, is a type of lease in which a finance company is seen as the legal owner of the asset for the time period of the lease, while the lease has control over the operation of the assets and will enjoy part of returns from asset and at the same time suffer economic risk from the use of the asset.
A financial lease is the method employed by business for the equipment purchase with a payment structure which would last for an agreed time period. It can be properly defined as an agreement in which the lessor receives lease payments to cover costs of ownership. The lessor will however be responsible for costs of maintenance, taxes and insurance.
A Finance Lease IFRS is similar in structure to a normal purchase agreement which is financed by making use of a term loan due to the fact that the payments are paid monthly. In contrast to a normal purchase agreement, the lessee doesn’t present the outstanding balance as debt, but indicates payments as expenses and retains the ownership title of the equipment. For the duration of the lease period, The finance company is seen as the rightful owner of the asset.
Types of Lease Financing
Types of Lease Financing is majorly characterized by:
- the lessee (customer or borrower) selecting an asset (equipment, vehicle, software);
- the lessor (finance company) purchasing the asset;
- the lessee will make use of the asset during the period of the lease;
- the lessee will make installment payments on the use of the asset;
- the lessor will gain a large part of the cost of the asset including interest from the installment payment made by the lessee;
- the lessee can obtain full ownership of the asset if he wants (e.g. by paying the last installment, or bargain option purchase price);
The terms of a finance lease agreement are similar to that of a hire purchase agreement and closed-end leasing due to the fact that the normal outcome is that the lessee will gain ownership of the asset after the lease has been settled. The difference between them is that, there have different methods of treating accounting variables and tax implications. There may be tax benefits for the lessee to lease an asset instead of purchasing it and it may be the sole reason for engaging in a finance lease.
Finance Lease on Accounting entries
Due to the fact that a finance lease is capitalized, it causes an increase of both assets and liabilities in the balance sheet. Due to this, there is a reduction in working capital but am increment in debt/equity ratio, which leads to the formation of leverage.
Expenses of finance leases are assigned between interest expense and principal value in similar ways to a bond or loan, this mean that in a statement indicating cash flows, portions of lease payments are recorded as part of operating cash flow and under financing cash flow. This will lead to an increment in operating cash flows.
The IFRS criterion for Finance Lease is:
If the ownership is transferred to the lessee by large amounts of risks and rewards, it can be said to be a finance lease. If it doesn’t fulfill this condition to be called a finance lease, then it is an operating lease. The transfer of risk to the lessee may be indicated by conditions which may include an option for the lessee to purchase the asset at a low price after the lease agreement has been fulfilled. The type of asset, the duration of the lease and the value of lease payment can also be considered as factors.
Leases are not classified under any particular set of rules made by the Finance Lease IFRS.