A finance lease (also known as capital lease or sales lease ) is a type of lease in which a finance company is usually the legal entity of the asset owner during the lease term, while the lessee not only has control of operations over assets, but also has a large share of economic risks and a return from changes in the underlying asset valuation.
More specifically, this is a commercial setting where:
- tenants (customers or borrowers) will select assets (equipment, vehicles, software);
- The lessor (finance company) will purchase the asset;
- the lessee will use the asset during the lease term;
- the lessee will pay a series of rentals or installments for the use of the asset;
- The lessor will recover most or all of the cost of the asset plus earn interest from the lease paid by the lessee;
- the lessee has the option to acquire ownership of the asset (e.g. the latest lease pay, or the purchase price of the bargaining option);
A finance lease has the same financial characteristic for hiring a closed purchase and lease agreement as a regular result is that the lessee will be the owner of the asset at the end of the lease but has different accounting treatment and tax implications. There may be tax benefits for the lessee to rent assets rather than buy them and this may be the motivation to get a finance lease.
Video Finance lease
Impact on accounting
- Since finance leases are capitalized, both assets and liabilities in the balance sheet increase. As a result, working capital decreases, but debt/equity ratios increase, creating additional influence.
- Financing lease costs are allocated between interest and principal costs such as bonds or loans; Therefore, in the cash flow statement, the portion of the lease payments is reported under the operating cash flow but the portion under the cash flows of the funding. Therefore, operating cash flow increases.
- Under conditions of operating lease, lease obligations are not recognized; Therefore, the low leverage ratio and return ratio (ROE and ROA) are exaggerated.
The main criteria of IFRS are:
If "substantially all risks and rewards" ownership is transferred to the lessee then it is a finance lease. If it is not a finance lease then it is an operating lease. The transfer of risk to the lessee may be indicated by the terms of the lease such as an option for the lessee to purchase the asset at a low price (usually residual value) at the end of the lease. The nature of the asset (whether it is likely to be used by anyone other than the lessee), the length of the lease (whether it covers most of the asset's useful life), and the present value of rent payments (whether they cover asset costs) may also be a factor.
IFRS does not provide a rigid set of rules to classify rent and there will always be boundary cases. Sometimes it is still possible to use leases to make the balance sheet look better, provided that the tenant can justify treating them as operating leases.
The classification of major transactions, such as the sale and rental of property, may have a significant effect on the account and on the size of financial stability such as gearing. However, keep in mind that an increase in financial balancing can be offset by worsening operational gearing and vice versa.
Maps Finance lease
Accounting treatment by country
International Financial Reporting Standards (IFRS)
In over 100 countries governing accounting using International Financial Reporting Standards, the control standard is IAS 17, "Lease". However, it is currently being removed, to be replaced by IFRS 16, "Lease" for the reporting period from 2019. While IAS 17 is similar in many respects to FAS 13 in the US, the IAS 17 avoids the "bright line" test (set the exact percentage as the limit ) on the lease term and present value of the rental price. 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 low-cost purchase option to purchase equipment with a value less than a reasonable market;
- the leasing term is for the main part of the economic life of the asset even if the title is not transferred;
- at the commencement of the lease, the present value of the minimum lease payments amounts to at least substantially all the fair value of the leased asset.
- the leased asset has special properties so that only tenants can use it without major modifications made.
IAS 17 is now transitioning to IFRS 16, as a joint project with US rental accounting standards. This standard is published in 2016, with companies requested to apply it in 2019 or earlier. The criteria to be classified as finance leases are similar to those above, but an assessment is needed - adequately meeting one requirement may not be enough.
Australia
In Australia, the lease-related accounting standard is AASB 117 'Leases'. AASB 117 was released in July 2004. AASB 117 'Leases' applies to rental accounting other than: (a) a lease to explore or use similar minerals, oil, natural gas and non-regenerative resources; and (b) licensing agreements for goods such as film films, videotapes, drama, manuscripts, patents and copyrights.
According to AASB 117, paragraph 4, the lease is: an agreement whereby lessors convey to the lessee in return for a payment or a series of payment of the right to use the 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." (AASB 117, p8) There are no strict guidelines on what is a finance lease, but the guidelines are provided in the standard.
India
A finance lease is one in which the risks and rewards incidental to ownership of the leased asset are transferred to the lessee but not the actual ownership. So in the case of a finance lease we can say that notional ownership is passed to the lessee. The amount paid as interest during the rental period is shown on the P/L DR side of the lessee
Features:
- can not be undone
- The lessor may or may not cover insurance, repair, maintenance, etc. Usually the tenant must bear all costs.
- The lessor can transfer the asset to the lessee at the end of the lease
- the lessee has the option to purchase the asset at an expected price quite lower than the value at the end of the lease period
United States
According to US accounting standards, finance leases (capital) are leases that meet 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 gives the lessee an option to buy the asset and the tenant is confident enough to use the option;
- the lease term is for the main part of the remaining useful life of the underlying asset (75% of the estimated useful life of the asset or greater);
- the present value of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all the fair value of the asset (90% of the original cost of the equipment).
- The asset has a special nature so it is not expected to have an alternative use for the lessor at the end of the lease term.
Following the GAAP accounting point of view, the lease is classified as essentially equivalent to the purchase by the lessee and capitalized on the balance sheet of the lessee. Refer to Statement of Financial Accounting Standards. 13 (FAS 13) for further details on classification and accounting.
Special Cases: Financial Leases under UCC Article 2A
This term sometimes means a special case of lease defined by Article 2A of the Uniform Commercial Code (specifically, Section 2A-103 (1) (g)). Such a lease of finance recognizes that some lessors are financial institutions or other business organizations that rent such goods solely as financial accommodation and do not wish to have any other collateral and involvement typically associated with rent by companies that are producers or traders of goods the. In the financing lease of UCC 2A, the lessee pays the payment to the lessor (and indeed does so, irrespective of any defects in the leased goods - this obligation is usually contained in "high or hell" clauses), but any claims relating to defects in goods the lease can be brought only to the actual supplier of the goods. UCC 2A financing leases are usually easy to identify because they generally contain a clause stating that the lease is considered a finance lease under UCC 2A.
See also
- Rent
- Leasing
- Operating leases
- Leveraged leasing
- Accounting for rent in the United States
References
Source of the article : Wikipedia
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