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Finance leases

What Is Finance Lease?

A finance lease, also known as a capital lease under previous accounting standards, is a type of commercial lease agreement that transfers substantially all the risks and rewards of asset ownership from the lessor to the lessee. Within the realm of Financial Accounting Standards and lease accounting, finance leases are distinguished by their economic substance, which closely resembles an asset purchase financed by debt rather than a simple rental arrangement. Under current GAAP (Generally Accepted Accounting Principles), specifically Accounting Standards Codification (ASC) Topic 842, both finance leases and operating leases are recognized on a company's balance sheet as a right-of-use asset and a corresponding lease liability.

History and Origin

The evolution of lease accounting standards has been a significant journey in financial reporting, primarily driven by the need for greater transparency regarding companies' true financial obligations. Historically, many companies used operating leases to keep substantial lease obligations off their balance sheets, a practice known as "off-balance sheet financing." This made a company's financial position appear stronger than it was, as significant liabilities were only disclosed in footnotes.10

To address this lack of transparency, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02, Leases (codified as ASC 842), in February 2016.9 This new standard fundamentally changed how companies account for leases, replacing the previous ASC 840. The core principle of ASC 842 is that a lessee should recognize the assets and liabilities arising from leases on the balance sheet.8 It was instituted to enhance transparency into lease liabilities for financial investors and to reduce off-balance sheet financing.7 The standard mandates that nearly all leases are capitalized, meaning they are recognized on the balance sheet, providing a more accurate depiction of a company's financial standing.6 Practitioners estimated that applying this new guidance would lead to approximately $2 trillion of lease liability being recorded on S&P 500 balance sheets alone.5

Key Takeaways

  • A finance lease transfers substantially all the risks and rewards of asset ownership to the lessee.
  • Under ASC 842, finance leases require the recognition of a right-of-use asset and a corresponding lease liability on the balance sheet.
  • The expense recognized on the income statement for a finance lease declines over the lease term, separating into interest expense and amortization of the right-of-use asset.
  • The calculation of the lease liability involves determining the present value of future lease payments discounted at the implicit or incremental borrowing rate.
  • Finance leases are typically used for long-term assets that a company intends to use for most of the asset's economic life.

Formula and Calculation

The initial measurement of a finance lease liability involves calculating the present value of future lease payments. The corresponding right-of-use (ROU) asset is then measured as the lease liability adjusted for certain items.

The formula for the initial lease liability is:

Lease Liability=∑t=1nLPt(1+r)t\text{Lease Liability} = \sum_{t=1}^{n} \frac{\text{LP}_t}{(1+r)^t}

Where:

  • (\text{LP}_t) = Lease payment in period (t)
  • (r) = The discount rate (either the rate implicit in the lease or the lessee's incremental borrowing rate)
  • (n) = Total number of lease payments over the lease term

The right-of-use asset is then calculated as:

ROU Asset=Initial Lease Liability+Initial Direct Costs−Lease Incentives Received+Prepaid Lease Payments\text{ROU Asset} = \text{Initial Lease Liability} + \text{Initial Direct Costs} - \text{Lease Incentives Received} + \text{Prepaid Lease Payments}

Subsequently, for a finance lease, the lease liability is reduced as payments are made, similar to a debt amortization schedule. The ROU asset is systematically amortized over the shorter of the asset's useful life or the lease term.

Interpreting the Finance Lease

Interpreting a finance lease requires understanding its impact on a company's financial statements, particularly under ASC 842. Since both a right-of-use asset and a lease liability are recorded, the balance sheet will reflect a more complete picture of a company's assets and obligations. This provides investors and creditors with a clearer view of the company's leverage.

On the income statement, a finance lease results in two separate expenses: interest expense on the lease liability and amortization expense on the right-of-use asset. These expenses generally decline over the lease term, as the interest component of the payment decreases over time. When analyzing a company with significant finance leases, it is crucial to consider how these entries affect profitability metrics, particularly in earlier periods of the lease term when expenses are higher.

Hypothetical Example

Consider a hypothetical company, "GreenThumb Landscaping Inc.," that enters into a five-year finance lease for a specialized, heavy-duty excavator. The fair value of the excavator is $100,000, and GreenThumb makes annual lease payments of $22,000 at the end of each year. The implicit interest rate in the lease, or GreenThumb's incremental borrowing rate, is 5%.

Year 1:

  1. Initial Lease Liability & ROU Asset: The present value of five annual payments of $22,000 at a 5% discount rate is approximately $95,257. This amount is recorded as both the initial lease liability and the right-of-use asset on GreenThumb's balance sheet (assuming no initial direct costs or incentives).
  2. Interest Expense: $95,257 (beginning lease liability) * 5% = $4,763.
  3. Amortization Expense: $95,257 / 5 years = $19,051 (assuming straight-line over the lease term).
  4. Lease Payment: GreenThumb pays $22,000.
    • $4,763 goes to interest expense on the income statement.
    • The remaining $17,237 ($22,000 - $4,763) reduces the lease liability.
  5. End of Year 1 Lease Liability: $95,257 - $17,237 = $78,020.
  6. End of Year 1 ROU Asset: $95,257 - $19,051 = $76,206.

This process continues annually, with the interest expense decreasing each year as the lease liability declines, and the amortization expense remaining constant (under straight-line depreciation).

Practical Applications

Finance leases are prevalent in industries requiring significant capital investment in equipment, such as manufacturing, transportation, and construction. Companies often opt for finance leases when they effectively want to own an asset for a long period but prefer not to use cash or incur traditional debt to purchase it outright.

From a practical perspective, understanding finance leases is crucial for:

  • Financial Analysis: Analysts use the information from finance leases on the balance sheet to accurately assess a company's leverage, debt-to-equity ratios, and overall financial health. The breakdown of cash flows from finance leases (financing activities for principal, operating activities for interest) also impacts liquidity analysis.
  • Investment Decisions: Investors evaluate how lease obligations impact future earnings and cash flows. A clear view of finance leases helps in making informed investment decisions.
  • Regulatory Compliance: Companies must adhere to rigorous accounting standards like ASC 842 for proper financial reporting. The comprehensive lease accounting guidance provided by resources like PwC helps ensure compliance.4

Limitations and Criticisms

While ASC 842 aimed to improve transparency, the implementation of the new lease accounting standards, including those for finance leases, introduced new complexities. Companies faced challenges in identifying all contracts that contain embedded leases and in gathering the necessary data for valuation, particularly the discount rate.3 The extensive data requirements and judgmental aspects, such as determining the lease term and the appropriate discount rate, can lead to significant effort and potential for error in applying the standard.

Furthermore, although finance leases bring liabilities onto the balance sheet, the distinction between finance and operating leases still exists under U.S. GAAP, unlike IFRS 16 (the international standard), which treats nearly all leases as finance leases for the lessee. This divergence can still lead to comparability issues for companies reporting under different standards. The complexity of accounting for leases, especially when managing new regulations, remains a significant concern for businesses.2

Finance Lease vs. Operating Lease

The primary distinction between a finance lease and an operating lease lies in the economic substance of the transaction and their subsequent accounting treatment on the income statement. Under ASC 842, both types of leases require the recognition of a right-of-use asset and a lease liability on the balance sheet, eliminating the "off-balance sheet" advantage that operating leases previously offered.

However, the income statement impact differs significantly. A finance lease is accounted for as if the lessee has purchased the asset, resulting in two separate expenses: interest expense on the lease liability and amortization expense on the right-of-use asset. These expenses typically decline over the lease term, leading to a front-loaded expense recognition. Conversely, an operating lease results in a single, straight-line lease expense recognized on the income statement over the lease term, generally on a straight-line basis, regardless of the actual payment schedule. This difference impacts profitability metrics and financial ratios over time.

FAQs

What is the main difference between a finance lease and an operating lease under ASC 842?

Under ASC 842, the main difference between a finance lease and an operating lease lies in their income statement impact. A finance lease shows separate interest and amortization expenses, which generally decrease over time. An operating lease presents a single, straight-line lease expense over the lease term. Both types are now recognized on the balance sheet.

Why were new finance lease accounting rules introduced?

New accounting standards for finance leases (ASC 842) were introduced primarily to enhance transparency in financial reporting by requiring companies to recognize virtually all lease assets and liabilities on their balance sheets. This eliminates previous "off-balance sheet" financing practices that obscured the true extent of a company's obligations, providing investors and other stakeholders with a clearer view of a company's financial health.1

Does a finance lease impact a company's debt?

Yes, a finance lease significantly impacts a company's perceived debt. By requiring the recognition of a lease liability on the balance sheet, finance leases increase a company's recorded liabilities, which can affect debt-to-equity ratios and other leverage metrics. This provides a more comprehensive picture of a company's financial obligations to analysts and creditors.