Finance lease

A finance lease (historically called a capital lease) is a lease agreement that is, in economic substance, a purchase financed with debt. Although the lessor holds legal title, the lessee controls the asset for most of its useful life and bears the risks and rewards of ownership, so accounting standards require the lessee to report the arrangement as if it had bought the asset with borrowed money.

Under US GAAP, a lease is classified as a finance lease if it meets any one of five criteria: ownership transfers to the lessee at the end of the term; the lease contains a purchase option the lessee is reasonably certain to exercise; the lease term covers the major part of the asset's economic life; the present value of lease payments equals substantially all of the asset's fair value; or the asset is so specialized it has no alternative use to the lessor.

The accounting follows from that classification. At commencement, the lessee records a right-of-use asset and a lease liability equal to the present value of the lease payments. Over the lease term, the lessee recognizes amortization expense on the asset and interest expense on the liability — two separate expense lines that are front-loaded, unlike the single straight-line expense of an operating lease.

The CMA Part 1 exam tests lease accounting within external financial reporting decisions. Be ready to apply the classification criteria, distinguish finance leases from operating leases, and describe the balance sheet and income statement effects of each — a frequent source of exam questions because the two lease types produce different expense patterns from otherwise similar contracts.