What is a Financial Lease?

what-is-a-financial-lease

With lease, a firm uses the asset which (legally) belongs to another party. Accounting-wise, we distinguish between short term lease, or operating lease, and long term lease, which is called financial lease (also called finance lease, or capital lease). The primary differentiating factor is that with financial lease, the risks (and rewards) are with the firm which is leasing, because the lease is long term and cannot be cancelled.

Application of the ‘substance over form’ principle, meaning that the economic reality (having the risks and rewards) is more important than the legal reality (not having legal ownership), has resulted in a difference in accounting treatment for operating lease versus financial lease.

With operating lease, the lease payments are expensed in the period where the asset is used (which is usually the period is which the lease term is paid). With financial lease, when the contract is signed, the firm recognizes an asset as well as a liability for the present value of the lease payments. The lease terms will include interest and repayment. As the lease terms are paid, interest expense is booked and the liability is repaid. The asset is depreciated over the economic lifetime.


Financial Lease Example

The firm has entered a long-term lease contract for a machine. The lease term is six years. Annually, the firm will pay 5,000 at the end of each year. The effective interest rate is 7.5%.

The present value of the payments is 23,469.23.

capital-lease-example

When the contract is signed, the firm makes the following journal entry:

T-account Debit Credit
Machines 23,469.23
Lease obligations 23,469.23

The repayment schedule is as follows:

financial-lease-example

Liabilities increase with (effective) interest, and are reduced with payments. Thus, the interest expense in the first year is 1,760.19, and the payment is 5,000. Hence, the liability reduces with the difference of 3,239.81.

For the first payment the following journal entry is made:

T-account Debit Credit
Interest expense 1,760.19
Lease obligations 3,239.81
Cash 5,000

Also, the asset is depreciated over its economic lifetime. Using straight line depreciation and assuming no residual value results in a yearly depreciation expense of 23,469.23 divided by six years equals 3,911.54 per year.

T-account Debit Credit
Depreciation expense 3,911.54
Accumulated depreciation machine 3,911.54

Currently, accounting principles have a cut-off point between operating lease and financial lease. If the (un-cancellable) term is at least 75% of the economic lifetime, the present value of the lease terms at least 90% of the purchase price of the asset, or the lease contract includes a provision by which the asset can be bought at the end of the term for a symbolic amount, then the lease is considered finance lease. However, currently the FASB and IASB (standard setting bodies of US GAAP and IFRS, respectively) are working on new accounting regulation where operating lease will be treated as financial lease. This new regulation is expected to be effective in 2011. (For the FASB, see here. For IASB, here.)


Financial Leases Explained

Key points:

– operational lease is a short term lease; lease payments are expensed in the period of usage (usually the period of the lease payment)

– financial lease (or, finance lease, capital lease) is a long term non-cancellable lease, where the risks and rewards are with the firm that leases the asset, and not the leasing-firm which has the legal ownership

– with financial lease, following the substance-over-form principle, the firm which leases the asset will capitalize the asset and show the present value of the lease obligations as a liability

– during the lease term, the lease obligation increases with interest (which is an expense) and is reduced with the lease payments

– currently, the accounting principles determine that a lease is financial when (1) the (non-cancellable) term of the lease is at least 75% of the economic lifetime, (2) the present value of the lease payments is 90% or more of the purchase price of the asset, or (3) at the end of the lease legal ownership is transferred for a symbolic (small) price

– new regulation for US GAAP and IFRS is expected in 2011, when operating lease will be treated like financial lease (capitalization of the asset, and recognizing the lease liability)

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