Finance lease

A finance lease is a lease that is primarily a method of raising finance to pay for assets, rather than a genuine rental. The latter is an operating lease.

The key difference between a finance lease and an operating lease is whether the lessor (the legal owner who rents out the assets) or lessee (who uses the asset) takes on the risks of ownership of the leased assets. The classification of a lease (as an operating or finance lease) also affects how it is reported in the accounts.

The UK, like many other countries, has tax rules that attempt to control the use of finance leases to reduce tax (reduced compared to what would have been paid if an asset had been financed in a different way).

From an accounting point of view the classification of leases as finance leases is very important. With a finance lease assets must be shown on the balance sheet of the lessee, with the amounts due on the lease also shown on the balance sheet as liabilities. This is intended to prevent the use of lease finance to keep the lease liabilities off-balance sheet.

The key IFRS criterion is:

  1. If "substantially all the risks and rewards" of ownership are transferred to the lessee then it is a finance lease.
  2. If it is not a finance lease then it is an operating lease.

The transfer of risk to the lessee may be shown by lease terms such as an option for the lessee to buy the asset at a low price (typically the residual value). at the end of the lease. The nature of the asset (whether is is likely to be used by anyone other than the lessee), the length of the lease term (whether it covers most of the useful life of the asset), and the present value of lease payments (whether they cover the cost of the asset) may also be factors.

IFRS does not provide a rigid set of rules for classifying leases and there will always be borderline cases. It is also still sometimes possible to use leases to make balance sheets look better, provided that the lessee can justify treating them as operating leases.

The classification of large transactions, such as sale and leasebacks of property, may have a significant effect on the accounts and on measures of financial stability such as gearing. However, it is worth remembering that an improvement in financial gearing may be offset by a worsening of operational gearing and vice-versa.

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