Finance Lease is a type of lease in which all the risks and rewards incidental to the ownership of the asset is transferred to the lessee. It is not necessary that the title of the asset is transferred to the lessee eventually.
Characteristics of Finance Lease
- In order to qualify as a finance lease, the following conditions must be fulfilled:
- the legal ownership of the asset is transferred to the lessee at the end of the lease term,
- the lessee is given the option to purchase the asset at a price significantly lower than the fair value of the asset,
- the asset is leased out for the majority of its useful life to the lessee,
- the asset leased out is of such nature that no one except lessee can use the asset unless any modifications are made,
- the present value of the minimum lease payment is substantially equal to or greater than the fair value of the leased asset, at the time of lease inspection,
- if the lessee cancels the lease before maturity, he or she has to bear all the expenses in connection with the cancellation,
- if the lessee is given the option to continue the lease at a price significantly lower than the market rent for a secondary lease term after the expiry of the initial lease tenure.
Example
Alpha acquired a new machine from Sigma leasing on 1st January, 2006. The total cost of this machine is $50,000. 12 half yearly payments of $5,000 are required to be paid in advance. The first payment is required to be paid on 1st January, 2006. The Alpha is given the option to continue the lease for a secondary term of 03 years at a cost of $200 on a yearly payment basis. The estimated useful life of the asset is 05 years.
Solution
The minimum lease payment = 12 x 5,000 = $60,000
Actual cost = $50,000
The asset is leased out for majority ofthe useful life, that is, 03 years.
The lessee has the option to continue the lease for a secondary period at a very lower price than the fair value.
Considering all the factors above, it is quite evident that the said transaction is treated a the Finance lease.
Journal Entries
| Particulars | Debit | Credit |
| To record asset and liabilities arising due to finance lease arrangements: | ||
| Asset under finance lease | ||
| Obligations under finance lease | ||
| To record depreciation over lease asset: | ||
| Depreciation expense | ||
| Allowance for depreciation | ||
| To record interest over the leased asset: | ||
| Interest expense | ||
| Accrued lease interest payable | ||
| To record payment of periodic lease liability and interest expense: | ||
| Obligations under finance lease | ||
| Accrued lease interest payable | ||
| Bank |