finance lease (also known as a capital lease or a sales lease) is a type of lease in which a finance

company is typically the legal owner of the asset for the duration of the lease, while the lessee not only
has operating control over the asset, but also has a some share of the economic risks and returns from
the change in the valuation of the underlying asset. [1]

More specifically, it is a commercial arrangement where:

the lessee (customer or borrower) will select an asset (equipment, software);

the lessor (finance company) will purchase that asset;

the lessee will have use of that asset during the lease;

the lessee will pay a series of rentals or installments for the use of that asset;

the lessor will recover a large part or all of the cost of the asset plus earn interest from the rentals paid
by the lessee;

the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option
purchase price);

A finance lease has similar financial characteristics to hire purchase agreements and closed-end leasing
as the usual outcome is that the lessee will become the owner of the asset at the end of the lease, but
has different accounting treatments and tax implications. There may be tax benefits for the lessee to
lease an asset rather than purchase it and this may be the motivation to obtain a finance lease.

A lessee should classify a lease as a finance lease when any of the following criteria are met:

Ownership of the underlying asset is shifted to the lessee by the end of the lease term.

The lessee has a purchase option to buy the leased asset, and is reasonably certain to use it.

The lease term covers the major part of the underlying asset’s remaining economic life. This is
considered to be 75% or more of the remaining economic life of the underlying asset.

The present value of the sum of all lease payments and any lessee-guaranteed residual value matches or
exceeds the fair value of the underlying asset.

The asset is so specialized that it has no alternative use for the lessor following the lease term.
As of the commencement date of a lease, the lessee measures the liability and the right-of-use asset
associated with the lease. These measurements are derived as follows:

Lease liability. The present value of the lease payments, discounted at the discount rate for the lease.
This rate is the rate implicit in the lease when that rate is readily determinable. If not, the lessee instead
uses its incremental borrowing rate.

Right-of-use asset. The initial amount of the lease liability, plus any lease payments made to the lessor
before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives
received.

When a lessee has designated a lease as a finance lease, it should recognize the following over the term
of the lease:

The ongoing amortization of the right-of-use asset

The ongoing amortization of the interest on the lease liability

Any variable lease payments that are not included in the lease liability

Any impairment of the right-of-use asset.

Definition: The Finance Lease and Operating Lease are the very common form of lease agreements that
an individual goes for. The lease is an agreement wherein the lessor grant rights to the lessee to use
lessor’s property in exchange for certain periodic payments.

Lease: The Finance Lease or Capital Lease refers to the agreement wherein the lessee gets the
ownership of the asset before the lease expires. Simply, the finance lease is the type of lease wherein
the lessor transfers all the risks and rewards associated with the asset to the lessee before the lease
agreement expires.

The lease is said to be the finance lease if it satisfies the following requirements:

Once the lease is expired, the lessee can purchase an asset at a bargain price.

The lessee gets the ownership of the asset after the lease expires.

The lease term is at least 75% of the estimated economic life of the asset.
The present value of lease payment is at least 90% of the asset’s value.

Operating Lease: The Operating Lease is the type of lease where the lessor does not transfer all the risks
and rewards related to the asset to the lessee when the lease expires. The term of operating lease is very
small as compared to the finance lease and following are the main features of the operating lease that
make if different from other leases:

The lease term is considerably less than the economic life of the equipment.

The lessee can terminate the lease even at the short notice and without any significant penalty.

When the ownership along with the risk and rewards lies with the lessor and is responsible for insuring
and maintaining the equipment, the lease is said to be a “wet lease”. Whereas, when the lessee bears
the cost of insurance and maintenance of the equipment, the operating lease is called as a “dry lease”.

Thus, the basic difference between the finance lease and operating lease is that in the case of the former
the lessor substantially transfers all the risks and rewards related to the assets to the lessee whereas, in
the latter form, no substantial transfer of risks and rewards of ownership are transferred to the lessee.

What Is a Capital Lease?

A capital lease is a contract entitling a renter to the temporary use of an asset, and such a lease has the
economic characteristics of asset ownership for accounting purposes. The capital lease requires a renter
to book assets and liabilities associated with the lease if the rental contract meets specific requirements.
In essence, a capital lease is considered a purchase of an asset, while an operating lease is handled as a
true lease under generally accepted accounting principles (GAAP).