A finance lease (also known as capital ease) is a lease in which the risks and rewards inherent in the leased asset are transferred to the lessee under the lease arrangement. Risks and rewards are deemed to be transferred when any of the following conditions are satisfied:
- The ownership of the leased asset is transferred to the lessee at the end of the lease term;
- The lease contains a bargain purchase option (which means that it entitles the lessee to purchase the asset at a significantly low price);
- The present value of the minimum lease payments is substantially equal (more than 90%) to the fair value of the leased asset at the inception of the lease; and
- The lease term is the major part (at least 70%) of the useful life of the leased asset.
Other indications that a lease should be classified as a lease include situations where the asset is specialized and cannot be used by a party other than the lessee without significant modifications and where the losses of the lessor in relation the lease are born by the lessee.
Company C in engaged in the manufacture of bicycles. It has leased some specialized production equipment from Company L. The useful life of the equipment is 6 years and the lease term is 5 years. The fair value of the equipment is $20 million and the present value of minimum lease payments made by Company C amounts to $15 million. The equipment is specifically designed for the operations of Company C and the lease contract contains a provision which allows Company C to either extend the lease at much lower rates or purchase the equipment at the end of 5 years for $1 million. The fair value of the equipment at the end of the lease term is expected to be $4 million.
This is definitely a finance lease as indicated by the following:
- The lease term is more than 70% of the useful life of the equipment;
- The lease contains a bargain purchase option; and
- The equipment is customized and cannot be used by another party without significant modifications.
Written by Obaidullah Jan, ACA, CFA