What is finance lease accounting?

Finance lease accounting refers to the method by which long-term lease agreements are recorded on the balance sheet. This approach requires the lessee to recognise both the asset and the corresponding lease liability, reflecting the ownership-like responsibilities tied to the leased asset. In this post, we explore the basics of finance lease accounting and its impact on financial statements, while also delving into key considerations for proper implementation.

Understanding finance leases

What defines a finance lease?

A finance lease is a lease agreement where the lessee essentially assumes the risks and rewards of ownership, even though the legal title remains with the lessor. This type of lease has specific criteria that distinguish it from other leases. It includes situations where the lease term is greater than 75% of the asset’s useful life, the present value of the lease payments is 90% or more of the asset’s fair market value or the lease includes an option for the lessee to purchase the asset at a bargain price.

How do finance leases differ from operating leases?

The key difference between finance and operating leases lies in the treatment of the asset and liability. In a finance lease, the lessee recognises both the leased asset and a lease liability on the balance sheet, as the lease is considered akin to purchasing the asset. Payments are recorded as both interest and principal repayments. In contrast, operating leases are treated as rental agreements, where the asset remains off the balance sheet and lease payments are expensed as operating costs.

Recognising finance leases

What are the criteria for classifying a lease as a finance lease?

To classify a lease as a finance lease, it must meet one or more of the following criteria:

1. The lease term must be at least 75% of the asset’s useful life.
2. The present value of the lease payments should be 90% or more of the asset’s fair market value at the start of the lease.
3. The lease may include an option for the lessee to purchase the asset at a bargain price.
4. The lease may automatically transfer the asset’s ownership to the lessee at the end of the term.

How does the new lease accounting standard affect finance lease classification?

Recent changes within the IFRS 16 requirements, have modified how leases are accounted for. Under these standards, almost all leases, including finance leases, must now be recorded on the balance sheet as a right-of-use asset and a corresponding lease liability. This change reduces the distinction between finance leases and operating leases since both now impact financial statements similarly.

Initial recording of finance leases

How is the asset value determined for a finance lease?

The value of the asset in a finance lease is calculated based on the present value of future lease payments. This is discounted using the interest rate implicit in the lease, or, if that rate is not determinable, the lessee’s incremental borrowing rate. This value reflects the total obligation assumed under the lease agreement.

What journal entries are required when recording a finance lease?

Upon the start of the lease, the initial journal entries would include debiting the leased asset (right-of-use asset) and crediting the lease liability for the present value of the lease payments. Each subsequent payment is recorded by debiting the lease liability for the principal portion, debiting interest expense for the interest portion and crediting cash for the full payment amount.

Depreciation and interest expense

How is depreciation calculated for finance lease assets?

Similar to owned assets, the leased asset is depreciated over its useful life or the lease term, whichever is shorter. Common depreciation methods include straight-line depreciation, declining balance or units of production. The asset’s value for depreciation is the present value of the lease payments calculated at the start of the lease.

How is interest expense recognised over the lease term?

Interest expense is calculated based on the remaining balance of the lease liability at the beginning of each period. The interest rate implicit in the lease (or the lessee’s incremental borrowing rate) is used to determine the interest expense. As payments are made, the principal portion of the lease liability reduces, leading to a decreasing interest expense over time.

Balance sheet impact of finance leases

How do finance leases affect assets and liabilities?

Upon initiation of a finance lease, the lessee records the leased asset as a right-of-use asset at the present value of the future lease payments. At the same time, a lease liability is recorded for the same amount, reflecting the obligation to make future payments.

What ratios are impacted by finance lease accounting?

Finance leases can significantly impact several financial ratios, including:

• Debt-to-equity ratio: This ratio increases due to the addition of lease liabilities, reflecting higher financial leverage.
• Return on assets (ROA): The addition of assets on the balance sheet may reduce ROA, as total assets rise without an immediate corresponding increase in net income.
• Asset turnover ratio: With more assets on the balance sheet, this ratio could decline, indicating lower asset efficiency.
• Interest coverage ratio: This ratio may be affected by the recognition of interest expenses tied to lease payments.

Income statement effects

How do finance leases influence reported net income?

Finance leases affect net income by recognising both interest expense and depreciation. Lease payments are split into principal and interest components, with interest expenses front-loaded in the early periods, leading to lower net income in those years.

What’s the difference in expense recognition between finance and operating leases?

The main difference in expense recognition between finance and operating leases is how costs are accounted for on the income statement. In a finance lease, the lessee records depreciation and interest expense, leading to potentially higher upfront expenses. Operating leases, however, treat the payments as rental expenses, leading to a more consistent and evenly spread expense pattern.

Cash flow statement considerations

How are finance lease payments reflected in the cash flow statement?

Finance lease payments are typically reflected in two sections of the cash flow statement:

• The principal portion is classified as a financing activity as it reduces the lease liability.
• The interest portion is classified as an operating activity as it reflects an interest expense.

What’s the impact on operating and financing cash flows?

The principal portion of the payment impacts the financing cash flow, while the interest portion impacts operating cash flows. This distinction is essential for understanding how lease obligations affect cash flow reporting.

Disclosure requirements for finance leases

What information must be disclosed in financial statements?

Disclosures related to finance leases must include the following:

• The nature and terms of the lease, including the lease term and renewal options.
• The total minimum lease payments due in the future, typically broken down by year.
• The interest rate implicit in the lease or the lessee’s incremental borrowing rate.
• The depreciation method used for the leased asset.
• Any purchase options or contingencies related to the lease.

How detailed should finance lease disclosures be?

Disclosures should provide enough detail to give stakeholders a clear understanding of the lease’s impact on the company’s financial position. This includes the lease terms, future minimum lease payments and the applicable interest rates.

Finance lease accounting software

What features should finance lease accounting software have?

Effective lease accounting software or lease management software should include features such as:

• Lease management: Tools for tracking lease terms, payment schedules and renewal options.
• Financial reporting: Automated generation of financial statements in compliance with standards such as IFRS 16 and ASC 842.
• Depreciation and amortisation: Functions to calculate and record depreciation of leased assets and interest on lease liabilities.
• Compliance and audit trails: Ensure compliance with accounting standards and maintain records for auditing.
• Integration capabilities: Integrate seamlessly with other accounting and ERP software.
• Dashboards and analytics: Provide clear visual tracking of lease obligations, cash flows and financial metrics.
• Customisable reporting: Generate tailored reports for management or regulatory needs.

How can software streamline finance lease management?

Finance lease accounting software can streamline the entire process by automating tasks like tracking lease terms, calculating depreciation and generating financial reports. It reduces manual data entry and ensures compliance with accounting standards, improving accuracy and efficiency in finance lease management.

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