A finance lease (also known as a capital lease) is a type of lease in which a finance company is typically the legal owner of the asset for the duration of the lease, while the lessee not only has operating control over the asset, but also has a substantial share of the economic risks and returns from the change in the valuation of the underlying asset.

A finance lease has similar financial characteristics to hire purchase agreements and closed-end leasing as the usual outcome is that the lessee will become the owner of the asset at the end of the lease, but has different accounting treatments and tax implications. There may be tax benefits for the lessee to lease an asset rather than purchase it and this may be the motivation to obtain a finance lease.

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Accounting for a direct financing lease

In a direct financing lease, the lessor accounts for the income from the sale over time as the lease payments are made. When the asset is leased, the lessor removes the asset's book value from its balance sheet and replaces it with a receivable equal to the book value. The internal rate of return on the asset-- the difference in cash flows from all the monthly payments less the book value of the asset when it was sold-- is used as the implied interest rate for the lease.

Strong Point

This arrangement is analogous to how a bank would account for a loan. Each month, the loan payment is paid, and the bank recognizes the interest portion of the payment as income and the principal portion goes to reduce the loan's balance.

As each payment is received in the direct financing lease arrangement, the lessor records income based on the implied interest portion based on the asset's internal rate of return and the remainder would be netted from the receivable on its balance sheet set up for each direct financed lease. The accounts are different, but the mechanism is very similar to the bank example.

Accounting for a sales type lease

While the direct financing accounting recognizes income over time as payments come in, the sales type lease accounts for a portion of that income immediately upon the inception of the lease, with the remainder accounted for over the term of the lease.

Strong Point

The lessor should recognize the gross profit from the lease immediately upon the start of the lease. The gross profit is calculated as the present value of the future cash flow from the lease less the book value of the asset at the start of the lease, discounted at the implied internal rate of return. The remaining value of the lease is then accounted for like the direct financing type as payments are received over time.

The sales type lease, therefore, allows the lessor to recognize more revenue at lease inception, while the direct financing arrangement recognizes no revenue up front but then catches up as the lease progresses.

catches up as the lease progresses. In both cases, the lessee should carry the asset on its balance sheet as a fixed asset. The lessor no longer shows the asset on its balance sheet, but instead will show the value of the financing agreement as a receivable.


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