Finance Lease: Definition, Conditions, and Accounting Treatment

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