Finance Lease

A lease agreement where the lessee assumes substantially all the risks and rewards of ownership of the asset.

A finance lease (historically referred to as a capital lease under US GAAP) is a commercial leasing arrangement that is treated as an asset purchase for accounting purposes. Under this structure, the lessee assumes substantially all the risks and rewards of ownership of the underlying asset. Consequently, the lessee records the leased property on its balance sheet as a non-current, right-of-use asset and records the present value of the future lease payments as a long-term liability. For investors, finance leases are critical because they represent a form of debt-like financing. Even though the company does not technically hold the legal title to the asset during the lease term, it is contractually obligated to make payments over a long horizon. This obligation directly impacts liquidity, leverage ratios, and solvency metrics, meaning analysts routinely add finance lease liabilities to traditional debt when calculating total leverage. Unlike operating leases, the expense for a finance lease is split on the income statement into depreciation of the asset and interest expense on the liability. This treatment can artificially inflate EBITDA and operating cash flow because the actual cash lease payments are not deducted as operating expenses. Investors must adjust their valuation models to account for this distortion, especially when comparing companies with different leasing strategies.

Company A enters into a 5-year finance lease for manufacturing equipment with a fair value of $500,000. The lease requires annual payments of $115,000 at a 5% discount rate. At inception, Company A calculates the present value of these payments to be $498,000. It records a Right-of-Use Asset of $498,000 and a Lease Liability of $498,000 on its balance sheet. In year one, instead of recording a $115,000 operating expense, it records $99,600 in depreciation ($498,000 / 5 years) and $24,900 in interest expense ($498,000 5%).