A finance lease is defined as a legal paper lease that enables the lessee to use an asset for quite a long time, almost equal to its useful life, and pay agreed fixed payments, thus giving the lessee an option to acquire the asset at the lease’s end. Finance leases are the best options through which businesses acquire possession of expensive holdings without making an upfront purchase. The company could take a finance lease, and all risks and rewards of ownership would be transferred to the lessee.
What is Finance Lease?
Lease accounting is handled in IFRS 16 by considering each entity while recognizing assets and liabilities associated with leases entered into. Finance leasing accounts are recorded with finance lease amortization and finance lease depreciation.
Finance Lease Journal Entries
The finance lease gets recorded in a company through journal entries. At lease inception, the lessee recognizes the lease component in terms of both the asset and liability related to it:
Journal Entry at Lease Inception:
Debit: Right-of-Use Asset (ROU)
Credit: Lease Liability
Each month, the lessee records the depreciation and amortization at the time of calculating the finance lease interest:
The Journal Entry for Depreciation:
Debit: Depreciation Expense
Credit: Accumulated Depreciation
Journal Entry for Interest Expense:
Debit: Interest Expense
Credit: Lease Liability
Finance Lease on Balance Sheet
The Finance Leases represent the asset and liability in a corporation’s financial document. Lease payments, thus reducing the lease liability allowing the finance lease depreciation to be set against the continuing asset value.
Finance Lease vs Operating Lease
Business is leasing property. A finance lease or an operating lease is the only clear option besides a finance lease. These kinds of leases account for changes. There is also a difference between a finance lease and an operating lease in terms of their effect on an organization financially. A finance lease is the long-term period of asset use, whereas an operating lease is termed the short period of use. The Finances Difference and Basic Definitions
In a finance lease, the lessee has the use of an asset for most of its useful life. The lessee pays fixed rentals and records the asset in its balance sheet. On expiry of the lease, the asset may be acquired.
Nonetheless, an operating lease will allow the lessee to use the asset for a limited period. None of the asset will be owned by the lessee (off-balance sheet) The lessor keeps ownership and records depreciation.
Accounting Treatment
Under a finance lease, you will record the assets and the liability in the lessee’s books. It also consists of computing the finance lease depreciation and finance lease interest in the income statement. An operating lease’s record only consists of expenses incurred from lease payments.
| Feature | Finance Lease | Operating Lease |
| Ownership Transfer | Usually, at the end of the lease | No transfer remains with the lessor |
| Balance Sheet Impact | Asset and liability recorded | Not recorded in lessee’s books |
| Expense Type | Depreciation and interest | Lease rental expense |
| Lease Term | Covers major asset life | Short-term use |
| Accounting Standard | Follows IFRS 16 rules | Considered an expense |
Finance Lease Accounting
The finance lease accounting ensures the business’s integrity concerning accounting norms. This states that lessees recognize and report financial leases on their balance sheets. At the lease commencement, the asset and liability must be recorded.
Finance Lease vs Capital Lease
People mistake a finance lease for a capital lease. A finance lease is governed by IFRS 16 while aging accounting standards govern a capital lease. Both pertain to asset transfer but differ in terminology. Key Differences
- A finance lease enters assets as right-of-use assets, while a capital lease will treat such assets as owned assets.
- The finance lease is governed by IFRS 16; older GAAP standards now guide the capital lease.
Finance Lease or Hire Purchase- Which Is Better for Business?
They all aid a business in acquiring assets but apply differently in the purchase process. A hire purchase allows it to acquire an asset after completing all payments. This is not always the case with finance leases.
- A finance lease needs the lessee to return the asset or buy it at fair market value.
- It provides evidence of possession of an asset once the last payment has been made.
- Asset accounting: a finance lease records the assets as right-of-use assets; hire purchase shows them as owned assets.
Different Pros and Cons of Finance Lease
A finance lease helps businesses access expensive assets, but it has limitations. They should weigh costs against benefits.
Advantages
- The business entity may initially use an asset without paying such an amount.
- Lease payments will be predictable and structured.
- Companies’ cash flow improvements will be triggered if they lease instead of buying.
Disadvantages
- Over the lease term, the borrowed amount is higher than buying outright.
- The company has to maintain the asset at its own cost.
- An early termination of this lease may entail some penalty.
Relevance to ACCA Syllabus
There is a significant emphasis on finance leases in both ACCA syllabus FR and SBR. This is critical in terms of the preparation of the financial statements and compliance with the International Accounting Standards (IAS) concerning proper classifications, recognition and accounting of finance leases. It is also relevant to more advanced topics (such as economic analysis and group reporting) so for ACCA candidates this is building block stuff.
Finance Lease ACCA Questions
Question 1: IFRS 16 dictates the accounting treatment of a finance lease in the lessee financial statements.
A) Income statement expense
B) The lease liability and the right of use asset
C. As an operating lease, as a rent expense
D) An off-balance sheet item
Ques: What does a lessee recognize during a finance lease? Ans: B) A lease liability and a right-of-use asset
Q2: What is a finance lease?
A) Lease(10% life useful)(90% remaining life useful)
At the end of the lease term, the lessee has the option to purchase the asset at fair market value.
C) Transferring of lease substantially all risks and rewards concept of owner
D) The asset remains on the lessor books for the duration of the lease
Ans: C) lease transfers substantially all risks and rewards of ownership to the lessee
Q3: What does the initial recognition of a finance lease liability on the balance sheet look like (IFRS 16)?
A) The fair value of the asset on realization date
B) Undiscounted lease payments payable
C) Length of lease (total money paid for lease).
D Fourth, I make sure that the lease payment, and the insidious recurring expense of monthly car maintenance, works into what
Ans: B) Undiscounted lease payments payable
Q4: How are interest expenses from finance lease treated in the financial statements?
A) As an operating expense
B) debit right-of-use asset
C) By allocating the lease payment to the lease liability
as an expense under the same item
D) Finance charge in the profit and loss statement
Ans: D) Finance charge in the profit and loss statement
Q5: When you recognize a finance lease, what does the new IFRS 16 say?
A) Higher EBITDA — as rental expenses are now below the operating profit line
B) A decrease in total assets if he is able to expense the lease payments as an expense first
C) Reductions in liabilities when repaying debt
D) Lease interest payments — growing operating cash outflows
Ans: A) Higher EBITDA — as rental expenses are now below the operating profit line
Relevance to CMA(US) Syllabus
Finance leases are mentioned in many direct effects e.g in Financial Reporting and Planning within USA CMA syllabus. Under US GAAP the finance leases can be reflected as an asset and liability on the balance sheet, both for the asset and the debt obligation. Leases Financials & Cashflows Such financial statements and cash flows have a very high degree of significance on the economic analysis and planning of enterprises.
Finance Lease CMA Questions
Q1: What are the criteria to classify a lease as finance lease US GAAP?
A) The term of lease is for less than a year
B) Lessee can normally give the asset back to lessee whenever he requires to use it.
C)This lease conveys a title or other qualification
D)Well, the lease renews automatically each year.
Ans: C) Leases that transfer ownership or meets at least one other condition set
Q2 — What effect does the financial lease have on the financial leverage ratio of the company?
A) Removes long-term debts/leverage
B) It raises leverage since lease liabilities are included in total debt
(d) None since lease payments are an expense
D) Operating income is up, thus leverage is down
Ans: B) The net debt will need to be reduced with rising lease liabilities
Q3: Where are you recording the depreciation on a finance lease?
A)Many of them do not factor in depreciation on their finance leases.
B)The lessee has a right-of-use asset and lease liability.
C) Less check whether an deprecation is recorded for leased asset
Ans: b) Depreciation on right of use asset recognised by lessee
Q4: A finance lease/capital lease does not affect the balance sheet.
A) The lease payment shall be recorded as operating cash outflow;
(B) Fund outflow from financing is Principal repayments
C) All payments under the lease are an investment outflow
D) finance lease payments are liabilities that capture the cost of leasing a cart/capital asset over time.
Ans: B) Financing cash outflows in financing cash outflows
Q5: The benefits to the lessee of a finance lease.
A) Expense accounts of lease fee payments.
B) On-Balance Sheet: The asset continues to be owned by the lessor
C) Obtaining an asset with no initial capital outlay
D. Leasing payments are off-balance sheet.
Ans: C) Obtaining an asset with no initial capital outlay
Relevance to US CPA Syllabus
You just have two commercial lease types; Finance leases or operating leases which are included in the FAR section of the US CPA exam. Which: Insight on Leases Candidates must understandı the effect leases have on financial statements, both on principles (IFRS and US GAAP) total (35,79; Statistics, 1,88 and 10,92 CPD) Finance lease is an important subject for CPA candidates; they enable auditing, regulatory reporting and decision producers informed by systems economy.
Finance Lease CPA Questions
Q1: To qualify as a finance lease under US GAAP, it must be at least 1 of what?
A) < 1 year lease term
B) The lessee must be able to direct the use of the mine
C) Annual leasing fee, eswe have to pay the lessee
D) The lessee must be entitled to the benefits and negative aspects of the asset
Answer C) Annual leasing fee, eswe have to pay the lessee
D) The asset sits on the lessor books for the lease term
Ans: B) A lessee assumes the risks and rewards related to an asset.
Q2: How does a finance lease affect a lessee’s balance sheet?
A) Recognized lease liability and right-of-use assets
B) Rent expense recognised when making lease payments
C) The lease asset is kept off-balance sheet.
D) Carrying amount of lease assets are classified as held for sale
Ans: A)Recognized lease liability and right-of-use assets
Q3: What is the recognition of a finance lease impact on financial statements?
A) Decline of assets and rise of liabilities
B)Total liabilities decrease since the lease is treated as an expense
C) Cash outflows for investing activities.
(d) decrease stockholders equity
Ans: A) Decline of assets and rise of liabilities
Q4: How do operating and finance leases differ?
A) In operating leases, the lessee obtains complete ownership upfront at the start of the lease.
B) The risks and rewards of ownership are delivered for finance leases
C) In finance lease, there is no requirement of lease payments
D) More depreciation on operating leases
Ans: B) he risks and rewards of ownership are delivered for finance leases
Q5: In which section of US GAAP interest expense on finance lease is fall?
A) Operating expenses
B) Financing expenses
C) Other income
D) Non-current liabilities
Ans: B) Financing expenses
Relevance to CFA Syllabus
By the way, from the CFA curriculum we also covered finance leases because they certainly are relevant to financial statement analysis (finance leases) Any time any analyst deals with a company, lease accounting provides information for that company’s capital structure and performance. CFA candidates will need to think about how finance leases affect leverage, cash flows, and performance.
Finance Lease CFA Questions
Q1: A finance lease is an asset that distorts a company’s “return on assets” negatively from one perspective.
A) The assets are higher the lower the ROA
B) ROA remains unchanged
C) ROA increases when depreciation drops
D) ROA does not get affected in finance leases transaction
Ans: A) The assets are higher the lower the ROA
Q2: The impact of finance leases on EBIT.
A) EBIT is actually higher because the lease payment takes the place of depreciation and interest
B) Because all lease payments are considered expenses, EBIT decreases
C) Financing leases do not affect EBIT D) Operating leases affect EBIT
D) If and only if a lease originated relates to the effect of EBIT
Ans: A) EBIT is actually higher because the lease payment takes the place of depreciation and interest
Q3: In financial statements, they have to report finance lease liabilities with classification, which are current liabilities or non-current liabilites?
A) One of the factors affecting only long-term liabilities.
B) Only as current liabilities
C) Noncurrent and current liabilities
D) No entry in liabilities
Ans: C) Current & non-current liabilities
Q4: Where do you record repayments of a finance lease?
A) Operating activities
B) Investing activities
C) Financing activities
D) Non-cash transactions
Ans: C) Financing activities
Q5: For the finance lease of the financial statement, what do investors pay attention to?
A) Assess hidden liabilities
C) Accumulating information to know from where the revenue is
D) To manipulate EBIT
Ans: A) Assess hidden liabilities
