Finance Lease as a Sale: A Closer Look

A finance lease, also known as a capital lease, is fundamentally treated as a sale for accounting and financial reporting purposes. While legally structured as a lease, it effectively transfers substantially all the risks and rewards of ownership of the leased asset to the lessee. This treatment differs significantly from an operating lease, where the asset remains on the lessor’s balance sheet.

The rationale behind treating a finance lease as a sale lies in the economic reality of the transaction. If a lessee has almost all the benefits and risks of owning the asset, even though they don’t hold legal title, the transaction is economically equivalent to a purchase financed through borrowing.

Criteria for Identifying a Finance Lease

Several criteria, often outlined in accounting standards like IFRS and U.S. GAAP, help determine whether a lease qualifies as a finance lease. If any of these conditions are met, the lease is typically classified as finance lease:

• Transfer of Ownership: The lease transfers ownership of the asset to the lessee by the end of the lease term.
• Bargain Purchase Option: The lessee has the option to purchase the asset at a price significantly below its expected fair market value at the end of the lease term.
• Major Part of Economic Life: The lease term covers a major part (often 75% or more) of the asset’s economic life.
• Present Value of Lease Payments: The present value of the minimum lease payments equals or exceeds substantially all (often 90% or more) of the asset’s fair value at the inception of the lease.
• Specialized Asset: The asset is of such a specialized nature that only the lessee can use it without major modifications.

Accounting Treatment for Lessee

For the lessee, a finance lease is accounted for by recording an asset (the leased asset) and a corresponding liability (the lease obligation) on the balance sheet. The asset is depreciated over its useful life (or the lease term, if shorter), and the lease obligation is amortized over the lease term, with each lease payment split into interest expense and a reduction of the lease liability. This results in a depreciation expense and interest expense appearing on the income statement.

Accounting Treatment for Lessor

The lessor accounts for a finance lease as a sale. They derecognize the asset from their balance sheet and recognize a receivable representing the future lease payments. They also recognize a profit or loss on the sale, similar to a typical sale of an asset. The lessor then treats the lease payments as repayment of the principal amount of the receivable and interest income.

Impact on Financial Statements

Treating a finance lease as a sale significantly impacts a company’s financial statements. For the lessee, it increases assets and liabilities on the balance sheet, affecting key ratios like debt-to-equity. It also impacts the income statement through depreciation and interest expense. Investors and analysts closely examine these impacts when evaluating a company’s financial health and performance.