Finance leases are in other words also called capital leases. Shortly of the meaning of finance lease – it’s an arrangement where the borrower chooses an asset, the finance company will purchase the asset and the borrower will use the selected asset during the period of lease. During this very same period the borrower pays to the finance company series of installments for the use of the asset. Usually the borrower will also have an option to acquire the asset, but that’s not relevant at the moment to the interest calculation methods.

On the accounting the principal installments and interest expenses are treated separately. First and foremost, the installments are not shown on the income statement, but the interest expense is. The reason for this comes from the recognition method of finance leases – the asset is recognized as a part of company’s assets and as such is depreciated over its useful life or term of the rental period, depending on which is shorter. However, the interest expense is charged on the income statement.

Usually the interest rate is fixed throughout the period and since the total payments are normally also equal, the interest expense varies. The expense needs to be allocated so as it produces constant periodic rate of interest on the remaining balance of the liability.

Accounting properly for finance leases is strictly speaking easy, but ever important. It is often first off forgotten that there may be a finance lease, however, when this is established, one needs to determine the value of the asset acquired under finance lease agreement. The borrower capitalizes the present value of the minimum lease payments (principal installments) as fixed assets and under liability. The present value of the minimum lease payments normally equates to the cash price, but may not obviously.

We’ll come to the tricky parts in our future posts so stay tuned. At the moment, consider the proper initial recognition of finance leases.