Finance Lease in Accounting: Definition, Criteria, and Example

What Is a Finance Lease?

A finance lease is a lease agreement where the lessee effectively controls and uses an asset while assuming most of the risks and rewards of ownership, even though legal ownership may not transfer immediately. For accounting purposes, a finance lease is treated similarly to purchasing an asset using borrowed funds, meaning both an asset and a lease liability are recorded on the balance sheet.

In accounting standards such as U.S. GAAP (ASC 842), the term finance lease replaced the older term capital lease. Under these standards, finance leases are recognized on the balance sheet and expensed through amortization of the asset and interest on the lease liability, rather than as a single lease (rent) expense.

Finance Lease vs. Operating Lease: What’s the Difference?

The main difference between a finance lease and an operating lease is how lease costs are recorded on the income statement. Finance leases split costs into amortization and interest, similar to buying an asset with debt, while operating leases record a single lease expense, similar to renting an asset.

Both finance and operating leases appear on the balance sheet under Generally Accepted Accounting Principles (GAAP) in the U.S. However, their expense recognition and financial impact differ as follows:

Finance Lease:

• The lessee assumes most of the risks and rewards of ownership.
• A right-of-use asset and lease liability are recorded on the balance sheet.
• Expenses are split into amortization and interest, which typically front-loads total expense.
• This treatment resembles owning the asset with borrowed funds.

Operating Lease:

• The lease is treated more like a rental arrangement.
• A right-of-use asset and lease liability are also recognized on the balance sheet under current standards.
• Lease payments are recorded as a single lease (rent) expense on the income statement.
• Ownership does not transfer, and expenses are recognized on a straight-line basis.

Lease Accounting Differences Under U.S. GAAP and IFRS Standards

The key difference between finance lease accounting in U.S. GAAP and IFRS is that IFRS uses a single lessee accounting model, while GAAP distinguishes between finance and operating leases. As a result, all lessee leases under IFRS are treated like finance leases on the income statement, whereas under GAAP, income statement treatment depends on lease classification.

The table below summarizes the main differences in how finance leases are accounted for under IFRS and U.S. GAAP.

Comparison Table: How Financial Leases Are Accounted for Under IFRS and GAAP

Classification

Under IFRS, lessees apply a single accounting model to most leases, recognizing a right-of-use asset and lease liability with expenses split into amortization and interest. Under GAAP, lessees classify leases as either finance or operating, which determines how lease costs appear on the income statement.

Income Statement Treatment

IFRS requires all lessee leases to recognize amortization and interest expense. Under U.S. GAAP, only finance leases use this approach, while operating leases recognize a single lease expense.

Cash Flow Statement Treatment

Under IFRS, principal repayments are financing cash flows, while interest expense may be classified as operating or financing. Under U.S. GAAP, interest expense is an operating cash flow, and principal repayments are financing cash flows for finance leases.

What Are the Four Criteria for a Finance Lease?

The four criteria for a finance lease are ownership transfer, bargain purchase option, lease term, and present value of payments. If any one of these criteria is met, the lease must be classified as a finance lease:

1. Ownership Transfer: Ownership of the underlying asset transfers to the lessee by the end of the lease term.
2. Bargain Purchase Option: The lease contains an option for the lessee to purchase the asset at a price that is expected to be sufficiently lower than the fair market value, making it reasonably certain the lessee will exercise the option.
3. Lease Term: The lease term covers the majority of the asset’s useful life (typically 75% or more).
4. Present Value of Payments: The present value of the lease payments equals or exceeds substantially all (usually 90% or more) of the fair value of the asset.

There is also a fifth criterion under updated US GAAP: if the asset is so specialized that it has no alternative use to the lessor at the end of the lease term, it is also deemed a finance lease.

If none of these criteria are met, the lease is classified as an operating lease.

Example of a Finance Lease in Accounting

In a finance lease, the lessee records both the leased asset and a matching lease liability at inception, then recognizes amortization and interest expense over the lease term — just like an asset purchased with a loan. This example shows how that treatment works in practice using leased equipment.

Suppose a company acquires equipment with a fair value of $2 million through a finance lease rather than purchasing it outright. The lease provides 100% financing over 10 years with a 6% interest rate and straight-line amortization of the asset.

At lease inception, the company records the equipment as a non-current asset (PP&E) at $2 million and recognizes an equal lease liability, split between current and long-term portions. 

Over time, the asset is amortized, interest expense is recognized on the outstanding liability, and lease payments reduce the principal balance.

Finance Lease Example – Year 1 Snapshot

Summary:

• The asset and liability are both recognized on the balance sheet.
• Amortization reduces the asset over time.
• Lease payments reduce the liability; interest and amortization hit the income statement.
• This approach closely resembles how a term loan might be accounted for when used to purchase equipment.

Finance Lease FAQs

What is the meaning of finance lease?

A finance lease is a long-term agreement where the lessee uses an asset and takes on most of the risks and rewards of ownership. For accounting purposes, finance leases are treated like a financed purchase. Companies record finance leases on the balance sheet as assets and corresponding lease liabilities.

What is another name for a finance lease?

Another name for a finance lease is capital lease. “Capital lease” is a historic term used until 2018 when the term was changed to “finance lease” under U.S. GAAP standards.

How do you determine if a lease is financial or operating?

To determine if a lease is finance or operating, assess whether it effectively works like a purchase. Under U.S. GAAP, a lease is treated as a finance lease if it transfers ownership, includes a bargain purchase option, covers most of the asset’s useful life, or has payments that equal most of the asset’s fair value.

Additional Resources

Lease Accounting Explained

Lessor vs Lessee

Operating Lease

CFI’s Accounting for Leases course

See all Accounting resources