Finance Lease Accounting Treatment

A finance lease, also known as a capital lease, is a type of lease that effectively transfers substantially all the risks and rewards of ownership of an asset to the lessee (the party using the asset). This differs significantly from an operating lease, where the lessor (the owner) retains those risks and rewards. Because a finance lease is essentially a purchase financed over time, its accounting treatment reflects that economic reality. Upon commencement of a finance lease, the lessee recognizes the asset and a corresponding lease liability on their balance sheet. The asset is recognized at the lower of its fair value or the present value of the minimum lease payments. The minimum lease payments include fixed payments, bargain purchase options (if reasonably certain to be exercised), and guaranteed residual value. The discount rate used to calculate the present value is typically the lessee's incremental borrowing rate, unless the interest rate implicit in the lease is readily determinable and lower. The recognized asset is depreciated over its useful life or the lease term, whichever is shorter, if ownership transfers to the lessee by the end of the lease term, or if a bargain purchase option is present. If neither of those conditions exist, the asset is depreciated over the lease term. The depreciation expense is recognized in the income statement, reducing the asset's carrying amount on the balance sheet. The lease liability is amortized over the lease term. Each lease payment is split into two components: a reduction of the lease liability and an interest expense. The interest expense is calculated using the effective interest method, applying the discount rate to the outstanding lease liability. This interest expense is also recognized in the income statement. Over the lease term, the lease liability is systematically reduced as payments are made. The balance sheet reflects the asset's carrying amount (original cost less accumulated depreciation) and the remaining lease liability. Significant disclosures are required for finance leases in the lessee's financial statements. These disclosures generally include: * A description of the leased asset and its use. * The lease term. * The depreciation policy applied to the leased asset. * A reconciliation of the total undiscounted lease payments to the present value of the lease liability. * A maturity analysis of the lease liabilities, showing the future undiscounted lease payments for each of the next five years and a total of the amounts for the remaining years. * Information about any contingent rent. For the lessor, a finance lease is treated as a sale of the asset. The lessor derecognizes the asset from its balance sheet and recognizes a lease receivable. The lease receivable is the present value of the lease payments. The lessor recognizes a gain or loss on the sale, calculated as the difference between the carrying amount of the asset and the present value of the lease payments. The lessor also recognizes interest income over the lease term using the effective interest method.