Finance Lease: An ACCA Perspective

A finance lease, under International Financial Reporting Standards (IFRS), specifically IFRS 16, is a lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset to the lessee. Essentially, the lessee is using the asset for the major part of its economic life, behaving economically as if they own it.

Key characteristics suggesting a finance lease include:

• Transfer of Ownership: The lease transfers ownership of the asset to the lessee by the end of the lease term. This is the clearest indicator.
• Bargain Purchase Option: The lessee has the option to purchase the asset at a price significantly below its fair value at the time the option becomes exercisable. This creates a strong incentive for the lessee to buy the asset.
• Major Part of Economic Life: The lease term is for the major part of the asset’s economic life, even if ownership is not transferred. A common guideline used by auditors is 75% or more.
• Present Value of Lease Payments: At the inception of the lease, the present value of the lease payments amounts to substantially all of the asset’s fair value. Another guideline used is 90% or more.
• Specialized Asset: The asset is of such a specialized nature that only the lessee can use it without major modifications.

Accounting Treatment for the Lessee:

Under IFRS 16, at the commencement of the lease, the lessee recognizes a right-of-use (ROU) asset and a lease liability on the balance sheet. The ROU asset represents the lessee’s right to use the asset over the lease term, and the lease liability represents the lessee’s obligation to make lease payments.

The ROU asset is initially measured at cost, which includes the initial amount of the lease liability, any initial direct costs incurred by the lessee, any lease payments made at or before the commencement date, less any lease incentives received. The asset is then depreciated over the shorter of the asset’s useful life or the lease term.

The lease liability is initially measured at the present value of the lease payments that are not paid at the commencement date, discounted using the interest rate implicit in the lease. If that rate cannot be readily determined, the lessee’s incremental borrowing rate is used. Subsequently, the lease liability is amortized, with the interest component recognized in the profit or loss. Each lease payment is allocated between the reduction of the lease liability and interest expense.

Impact on Financial Statements:

Recognizing a finance lease significantly impacts the lessee’s financial statements. Key impacts include:

• Increased Assets and Liabilities: The ROU asset and lease liability are added to the balance sheet, increasing total assets and liabilities.
• Depreciation Expense: The depreciation of the ROU asset is recognized in the profit or loss.
• Interest Expense: The interest on the lease liability is recognized in the profit or loss.
• Cash Flow Statement: The repayment of the principal portion of the lease liability is presented as a financing activity, while the interest portion can be presented either as an operating or financing activity, depending on the accounting policy adopted.
• Ratios: Key financial ratios, such as debt-to-equity and asset turnover, are affected by the recognition of the lease.

Understanding the nuances of finance leases and their accounting treatment is crucial for ACCA students, as it is a common topic in various exams and a fundamental concept in financial reporting.