A finance lease or capital lease is a type of lease. It is a commercial arrangement where:
- the lessee (customer or borrower) will select an asset (equipment, vehicle, software);
- the lessor (finance company) will purchase that asset;
- the lessee will have use of that asset during the lease;
- the lessee will pay a series of rentals or installments for the use of that asset;
- the lessor will recover a large part or all of the cost of the asset plus earn interest from the rentals paid by the lessee;
- the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option purchase price);
The finance company is the legal owner of the asset during duration of the lease.
However the lessee has control over the asset providing them the benefits and risks of (economic) ownership[1].
Comparison with operating lease
A finance lease differs from an operating lease in that:
- in a finance lease the lessee has use of the asset over most of its economic life and beyond (generally by making small 'peppercorn' payments at the end of the lease term).
In an operating lease the lessee only uses the asset for some of the asset's life.
- in a finance lease the lessor will recover all or most of the cost of the equipment from the rentals paid by the lessee.
In an operating lease the lessor will have a substantial investment or residual value on completion of the lease.
- in a finance lease the lessee has the benefits and risks of economic ownership of the asset (e.g. risk of obsolescence, paying for maintenance, claiming capital allowances/depreciation).
In an operating lease the lessor has the benefits and risks of owning the asset[2].
The U.S. Financial Accounting Standards Board and the International Accounting Standards Board announced in 2006 a joint project to comprehensively review lease accounting standards. In July 2008, the boards decided to defer any changes to lessor accounting, while continuing with the project for lessee accounting, with the stated intention to recognize an asset and obligation for all lessee leases (in essence, making all leases finance leases). The projected completion of the project is now 2011. [3] [4]
Under US accounting standards, a finance (capital) lease is a lease which meets at least one of the following criteria:
- ownership of the asset is transferred to the lessee at the end of the lease term;
- the lease contains a bargain purchase option to buy the equipment at less than fair market value;
- the lease term equals or exceeds 75% of the asset's estimated useful life;
- the present value of the lease payments equals or exceeds 90% of the total original cost of the equipment.
Following the GAAP accounting point of view, such a lease is classified as essentially equivalent to a purchase by the lessee and is capitalized on the lessee's balance sheet. See Statement of Financial Accounting Standards No. 13 (FAS 13) for more details of classification and accounting.
Special Case: Finance Leases under UCC Article 2A
The term sometimes means a special case of lease defined by Article 2A of the Uniform Commercial Code (specifically, Sec. 2A-103(1) (g)). Such a finance lease recognizes that some lessors are financial institutions or other business organizations that lease the goods in question purely as a financial accommodation and do not want to have the warranty and other entanglements that are usually associated with leases by companies that are manufacturers or merchants of such goods. Under a UCC 2A finance lease, the lessee pays the payments to the lessor (and indeed must do so, regardless of any defect in the leased goods – this obligation usually being contained in a "hell or high water" clause), but any claims related to defects in the leased goods may be brought only against the actual supplier of the goods. UCC 2A finance leases are usually easy to identify because they commonly contain a clause specifically declaring that the lease is to be considered a finance lease under UCC 2A.
International Financial Reporting Standards
In the over 100 countries that govern accounting using International Financial Reporting Standards, the controlling standard is IAS 17, "Leases". While similar in many respects to FAS 13, IAS 17 avoids the "bright line" tests (specifying an exact percentage as a limit) on the lease term and present value of the rents. Instead, IAS 17 has the following five tests. If any of these tests are met, the lease is considered a finance lease:
- ownership of the asset is transferred to the lessee at the end of the lease term;
- the lease contains a bargain purchase option to buy the equipment at less than fair market value;
- the lease term is for the major part of the economic life of the asset even if title is not transferred;
- at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
- the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.
Treatment in Australia
In Australia the accounting standard pertaining to lease is AASB 117 'Leases'. AASB 117 was released in July 2004. AASB 117 'Leases' applies to accounting for leases other than: (a) leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources; and (b) licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.
According to AASB 117, paragraph 4, a lease is: an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.
A lease is classified as a finance lease if it "transfers substantially all the risks and rewards incidental to ownership of an asset." (AASB 117, p8) There are no strict guidelines as to what constitutes a finance lease, however guidelines are provided within the standard.
Impact on accounting
- Since a finance lease is capitalized, both assets and liabilities (current and long-term ones) in the balance sheet increase. As a consequence, working capital decreases, but the debt/equity ratio increases, creating additional leverage.
- Finance lease expenses are allocated between interest expense and principal value much like a bond or loan; therefore, in a statement of cash flows, part of the lease payments are reported under operating cash flow but part under financing cash flow. Therefore, operating cash flow increases.
- Under operating lease conditions, lease obligations are not recognized; therefore, leverage ratios are understated and ratios of return (ROE and ROA) are overstated.
See also
External links
References
- ^ The Principles & Practices of Leasing by K V Kamath et al published by Lease Asia 1990 especially chapter 2
- ^ Leasing by D Wainman published by Waterlow Publishers 1991 especially chapter 4
- ^ FASB Project Update: Leases
- ^ IASB Current Projects: Leases
