Finance Lease: Definition, Conditions, and Accounting Treatment

This article explains the concept of finance lease, its conditions, and accounting treatment for both lessee and lessor. It also covers the disclosures required to be made by both parties. The article is relevant for students studying corporate accounting and reporting.

CORPORATE ACCOUNTING AND REPORTING

A lease is said to be finance lease when all the risks and rewards are transferred
from lessor to the lessee is known as a finance lease. All the other leases are known
as operating lease. The lessor is the actual owner of the asset who gives the lessee
a right to use the asset in exchange of lease rentals. So, we can say that the lessee
is in a position of the tenant. There is a lease agreement sign between both the
parties which states the terms and conditions of the lease. Few of the points that are
mentioned in the lease agreement are- decryption of the property, terms of the rent,
lease termination date, details about the occupants of the property, details regarding
the security details etc (Girard, 2014).
There are certain conditions that have to be fulfilled in order to classify lease as
finance lease. They are: The ownership which includes the risk and rewards of the
asset is transferred from the lessor to the lessee at the termination of the lease
period. The lease term that is decided is the maximum part of the economic life of
such asset. The assets that are leased are of a special nature and that the lessee is
not allowed to make many changes before using it (Holtzman, 2013). At the
beginning of the lease term, the present value of the lease payments must be almost
equal to the fair value of the asset. The lessee is provided with a choice to buy the
asset at a price that is substantially lower than the fair value of the asset. If the
lessee cancels the lease in the middle, then the loss of the lessor on cancellation will
be borne by the lessee. The lessee is permitted to continue using the asset even
when the lease term is over and pay lease rental that is much lower when compared
to the fair lease rentals.
Accounting treatment of a finance lease in the books of lessee: The asset that is
given on lease must be recorded as an asset in the balance sheet and also the
rentals payable in future should be recorded (Mattessich, 2016).The rental payments
must be distributed between a finance charge or a decrease in the payment
obligation. The finance charge that has been charged must be allocated to the
specific accounting period which will help in producing a constant periodic rate of
return (McLaney & Adril, 2016).
Accounting treatment in the books of the lessor: The amount of money that is due
from the lessee must be shown on the asset side of the balance sheet as debtors.
The gross earnings should be allocated to the each specific accounting periods in

order to obtain information about the constant periodic rate of return on the basis of
net cash investments.
There are some disclosures that has to be made by both the lessor and lessee in
case of the finance lease.
The disclosures require to be made by Lessee are- He is required to show the
carrying amount of the asset. He must reconcile between the minimum lease
payments and the present value of such minimum lease payments. If there is any
contingent rent that is shown as expense in the books of accounts (Siciliano, 2015).It
should also disclose about the important lease arrangements, contingent rent
provisions if any, purchase option, renewal option, dividend restrictions and also
further leasing the asset. The amount of minimum lease payment at the end of
reporting period must be disclosed.
The lessor must disclose the reconciliation between the present value (PV) of the
minimum lease payments and the gross investment. He must also disclose the PV of
the lease payments as well as gross investments for next year and beyond five
years. He should also disclose unearned finance income and the unguaranteed
residual values.The contingent rent that has been recognised as expense in the
profit and loss account (Taillard, 2013). He is required to provide brief description
about the important leasing agreements.Accumulated allowance for the uncollectible
lease payments that are yet to be received.

Bibliography
Girard, S. L. (2014). Business finance basics. Pompton Plains, NJ: Career Press.
Holtzman, M. (2013). Managerial Accounting For Dummies. Hoboken, NJ: Wiley.
Mattessich, R. (2016). Reality and accounting. [S.I.]: Routledge.
McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United
Kingdom: Pearson.
Siciliano, G. (2015). Finance for Nonfinancial Managers. New York: McGraw-Hill.
Taillard, M. (2013). Corporate finance for dummies. Hoboken, N.J.: Wiley.