What a finance lease in essence is, is you buying an asset with a support of another party, that’s initially financing the purchase. Usually it’s done in the form that the financing party is purchasing the asset and is leasing it forward to you. This transaction is really common these days, however the disclosure on the statement of cash flows is something that can go messy. Hence with the following we hope to set out the basics.
First off, on the balance sheet you recognize the asset and the liability. An asset is obviously the asset you just leased, but with this you also need to recognize the liability against the financing party, who initially bought the asset. So with debit you increase your assets and with credit the liabilities. Now when you think about it, did you actually pay anything at this stage? No, you didn’t.
Okay, let’s continue to the income statement. On your income statement the initial purchase is not recognized obviously, but what is, is future depreciation of the asset. The assets bought under finance lease are always depreciated during the shorter of either the rental period or the useful life deemed to the asset.
As for the statement of cash flows now, the initial acquisition of the asset in question is never disclosed purely because you actually didn’t pay anything for the asset. It’s not an outflow of cash initially and is recognized only in future periods when you start paying off the finance lease liability.
If you would recognize the acquisition of the asset under investing activities and would show the total value of the asset on your balance sheet as an outflow on the statement of cash flows, you’d eventually end up showing twice the cash outflow. So keeping that in mind, make sure assets bought under finance lease are never shown under investing activities and also bear in mind that the initial acquisition is never a full outflow. Your cash outflows will always be your lease payments, regular and afar a certain period.
Dears
– If I rent land for ten years and we already pay 10 million in advanced
at first it will be financial lease or other
also it will not Classified under investing outflow where it have to be
please advice me
Hello and thank you for the question!
Now, whether a lease is a finance or an operating lease depends on various things:
– will the ownership change (i.e. will you get the title for the land after the lease period?)
– will you get the option to buy the land after the lease period with a significantly lower price than a market price would be for this land?
– does the present value of minimum lease payments amount to a significant part of the fair value of the asset?
There are a few other conditions which in case of renting a land don’t really apply. In case one of those questions is answered with a “yes”, the lease is indeed a finance lease. If not, it’s an operating lease.
As for the 10 million advance payment, please do note that if it’s an operating lease after all, it will be recognized into expenses over the rental period and the rest is always shown on the balance sheet as a prepaid expense. It acts the way all other prepaid expenses do on the statements. If however it’s a finance lease, this prepaid 10 million is part of the cost price of the asset.
On the face of the statement of cash flows, finance lease payments are always shown under investing activities and operating lease payments are shown under operating activities, as the name suggests. Do note however that those payments are not shown separately, but they’re part of either the “operating results for the period” or however you’ve called the line on the statement. Essentially they’re part of the operating results you’re going to apply changes to if you’re using the indirect method or in case of direct method, they’re part of “payments done to suppliers”. The prepayment you already did however would be part of your “changes in receivables and prepayments” in case of an indirect method or part of “payments done to suppliers” in case of direct method.
Hope it helped. If you have any more questions, please fire them our way.