What is a Finance Lease?

A finance lease is a leasing arrangement in which the lessee obtains ownership of the leased asset by the end of the lease term.

When to Classify a Lease as 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.

Related AccountingTools Courses

Accounting for Leases

How to Measure a Finance Lease

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.

Accounting for a Finance Lease

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

Example of the Accounting for a Finance Lease

On January 1, 2025, Flitter Inc. enters into a lease agreement to rent specialized manufacturing equipment. The lease term is 5 years, which covers the majority of the equipment’s 6-year economic life. The present value of the lease payments amounts to $120,000, and Flitter has the option to purchase the equipment at the end of the lease for a nominal amount. Based on these facts, the lease meets the criteria for classification as a finance lease because it effectively transfers control of the asset to Flitter.

The initial journal entry on January 1, 2025 is a debit of $120,000 to the right-of-use asset and a $120 credit to the lease liability account. These amounts represent the present value of the lease payments.

Assuming that Flitter pays $2,500 monthly, where part of this amount is interest, while the rest reduces the liability. If the first month's interest is calculated as $600, then the company debits its interest expense account for $600, debits the lease liability account for $1,900, and credits the cash account for $2,500.

At the same time, Flitter depreciates the right-of-use asset. Assuming straight-line depreciation, the company will depreciate $24,000 of the asset per year, or $2,000 per month. Therefore, the monthly entry is a $2,000 debit to depreciation expense and a $2,000 credit to accumulated depreciation.

Accounting for a Capital Lease

Operating Lease Accounting

Sales-Type Lease Accounting

The Difference Between a Finance Lease and an Operating Lease