A lease agreement that qualifies as a finance lease is an important concept in the world of accounting. It is a type of lease arrangement that enables companies to finance the purchase of an asset over a period of time. In this article, we will delve further into what exactly a finance lease is and the criteria that need to be satisfied for a lease to qualify as a finance lease.
What is a Finance Lease?
A finance lease is a type of lease agreement that is structured in a way that enables the lessee (the individual or company leasing the asset) to acquire ownership of the asset at the end of the lease period. It is also sometimes referred to as a capital lease or a full-payout lease.
A finance lease is different from an operating lease, where the lessor (the company owning the asset) retains ownership of the asset and the lessee only has the right to use it for a specific period of time. In an operating lease, the lessee does not take on the risks and rewards associated with ownership of the asset.
Criteria for a Lease to Qualify as a Finance Lease
To qualify as a finance lease, a lease agreement must meet certain criteria outlined in accounting standards such as IFRS 16 and ASC 842. The following are the key criteria that need to be satisfied:
1. Ownership: The lease agreement should transfer ownership of the asset to the lessee at the end of the lease period.
2. Bargain Purchase Option: The lessee should have the option to purchase the asset at a price that is significantly lower than its fair market value. This option should be exercised by the lessee.
3. Lease Term: The lease term should be for a significant portion of the asset`s useful life. A general rule of thumb is that the lease term should be at least 75% of the asset`s useful life.
4. Present Value of Lease Payments: The present value of lease payments should be at least 90% of the fair market value of the asset at the start of the lease agreement.
5. Risks and Rewards of Ownership: The lessee should assume the risks and rewards associated with ownership of the asset. This means that the lessee should be responsible for maintenance, repairs, insurance, and other costs associated with the asset.
Benefits of a Finance Lease
A finance lease enables companies to acquire the use of an asset without having to make a large upfront investment. This allows companies to preserve their working capital and invest it in other areas of their business. Additionally, because the lessee assumes the risks and rewards of ownership, they can take advantage of any potential appreciation in the value of the asset.
Conclusion
A lease agreement that qualifies as a finance lease is an important concept in the world of accounting. Understanding the criteria that need to be satisfied for a lease to qualify as a finance lease is important for companies that are looking to finance the purchase of an asset. By structuring a lease agreement as a finance lease, companies can preserve their working capital and take advantage of any potential appreciation in the value of the asset.