Accounting for a finance lease

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What is a Finance Lease?

A finance lease is a leasing arrangement in which the lessee obtains ownership of the leased asset by the end of the lease term.

When to Classify a Lease as a Finance Lease

A lessee should classify a lease as a finance lease when any of the following criteria are met:

  • Ownership of the underlying asset is shifted to the lessee by the end of the lease term.

  • The lessee has a purchase option to buy the leased asset, and is reasonably certain to use it.

  • The lease term covers the major part of the underlying asset’s remaining economic life. This is considered to be 75% or more of the remaining economic life of the underlying asset.

  • The present value of the sum of all lease payments and any lessee-guaranteed residual value matches or exceeds the fair value of the underlying asset.

  • The asset is so specialized that it has no alternative use for the lessor following the lease term.

Related AccountingTools Courses

Accounting for Leases

How to Measure a Finance Lease

As of the commencement date of a lease, the lessee measures the liability and the right-of-use asset associated with the lease. These measurements are derived as follows:

  • Lease liability. The present value of the lease payments, discounted at the discount rate for the lease. This rate is the rate implicit in the lease when that rate is readily determinable. If not, the lessee instead uses its incremental borrowing rate.

  • Right-of-use asset. The initial amount of the lease liability, plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.

Accounting for a Finance Lease

When a lessee has designated a lease as a finance lease, it should recognize the following over the term of the lease:

  • The ongoing amortization of the right-of-use asset

  • The ongoing amortization of the interest on the lease liability

  • Any variable lease payments that are not included in the lease liability

  • Any impairment of the right-of-use asset

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The Difference Between a Finance Lease and an Operating Lease