A Comprehensive Guide to Financing Lease Accounting

Financing lease accounting is an essential aspect of financial management for businesses that utilize leasing arrangements. In this comprehensive guide, we will explore the concept of financing leases, discuss the criteria for classifying a lease as a finance lease, and delve into the accounting principles and procedures associated with financing lease transactions.

What is a Finance Lease?

A finance lease is a type of leasing arrangement in which the lessee obtains ownership of the leased asset by the end of the lease term. Unlike operating leases, which are treated as rental agreements, finance leases involve the transfer of significant risks and rewards of ownership to the lessee.

Lease Liability

One of the key elements of financing lease accounting is the recognition and measurement of lease liability. When a finance lease is entered into, the lessee is required to recognize a liability equal to the present value of the lease payments over the lease term.

Right-of-Use Asset

In addition to lease liability, the lessee also recognizes a right-of-use asset on the balance sheet. This asset represents the lessee's right to use the leased asset during the lease term. The initial measurement of the right-of-use asset is typically equal to the lease liability, adjusted for any lease incentives or initial direct costs.

When to Classify a Lease as a Finance Lease

Determining whether a lease should be classified as a finance lease or an operating lease requires an evaluation of specific criteria. The most common criteria include:

• Transfer of Ownership: If the lease agreement grants the lessee the option to purchase the leased asset at a price significantly below its fair value, it is likely to be classified as a finance lease.
• Lease Term: If the lease term covers a major part of the economic life of the leased asset, it indicates that the lessee has effectively assumed the risks and rewards of ownership, leading to classification as a finance lease.
• PV of Lease Payments: If the present value of lease payments exceeds a substantial portion of the fair value of the leased asset, the lease is likely to be classified as a finance lease.

Accounting for a Finance Lease

Accounting for a finance lease involves recognizing and measuring lease liability, right-of-use asset, and subsequent lease payments. The lessee typically amortizes the lease liability over the lease term, recognizing interest expense on the outstanding liability and reducing the liability with each lease payment.

Recognition and Measurement of Finance Leases

The initial measurement of a finance lease involves recognizing the right-of-use asset and the lease liability. Subsequently, the lessee amortizes the right-of-use asset and recognizes interest expense on the lease liability. The lease payments are allocated between interest expense and reduction of the lease liability.

Lease Accounting Changes

Lease accounting standards have undergone significant changes in recent years, particularly with the introduction of ASC 842 and IFRS 16. These changes aim to improve transparency and provide a more accurate representation of leasing arrangements on financial statements.

IAS 17 Changes to IFRS 16

One of the notable changes is the transition from IAS 17 to IFRS 16. IFRS 16 eliminates the distinction between finance leases and operating leases for lessees, requiring the recognition of right-of-use assets and lease liabilities for most leases.

Conclusion

Financing lease accounting is a complex area of financial management, but understanding the principles and procedures involved is crucial for businesses that rely on leasing arrangements. By properly recognizing and measuring lease liabilities and right-of-use assets, businesses can ensure compliance with accounting standards and accurately present their financial position. With the changes in lease accounting standards, it is essential for businesses to stay updated and adapt their accounting practices accordingly.