Finance Lease

At commencement the lessee measures the lease liability as the present value of the remaining lease payments, discounted at the interest rate implicit in the lease when that rate is determinable and at the lessee's incremental borrowing rate otherwise. Payments included are fixed amounts, in-substance fixed payments, index-linked variable payments at the opening index level, amounts expected under residual value guarantees, and the exercise price of a purchase option that is reasonably certain to be taken.

The right-of-use asset starts at the liability amount, adjusted upward for initial direct costs and prepaid rent and downward for lease incentives received. Because the discount rate drives both figures, a lower assumed rate inflates the asset and the liability simultaneously, which is why disclosure of weighted-average discount rates and lease terms matters when comparing lease-heavy issuers.

The liability is serviced like an amortising loan. Each period's interest equals the discount rate applied to the opening liability balance; the cash payment less that interest reduces principal. As principal falls, interest falls, so the interest charge is largest in the first year and smallest in the last. The right-of-use asset, by contrast, is normally amortised on a straight-line basis over the shorter of the lease term and the asset's useful life, or over the useful life when ownership transfers or a purchase option is reasonably certain.

Combining a declining interest charge with a constant amortisation charge produces total expense that is higher than straight-line rent early in the lease and lower late in the lease. Over the full term the total expense is identical to the sum of the cash payments, so the difference is purely one of timing, but it depresses early-year net income, ROA and return on equity relative to an operating lease of the same asset.

IFRS 16 applies a single lessee model: with narrow exemptions for short-term and low-value leases, every lease is accounted for in the finance-lease manner. US GAAP retains a dual model under ASC 842, so a lessee must test the arrangement against ownership transfer, a purchase option reasonably certain of exercise, a lease term covering a major part of the asset's economic life, a present value of payments amounting to substantially all of fair value, and specialised-asset status. Failing all five leaves an operating lease with a single straight-line rent expense.

The cash flow statement is where classification still bites under US GAAP. Finance lease principal repayments are financing outflows and only the interest portion touches operating cash flow, whereas operating lease payments are entirely operating outflows. Finance classification therefore reports higher CFO for identical cash spending.

Expect to be asked to compute the opening liability from a payment stream and discount rate, build a one- or two-year amortisation schedule, and split the payment into interest and principal. From there, be able to state the direction of the effect on EBIT, EBITDA, net income, total assets, total liabilities, the debt-to-equity ratio and the current ratio, and to identify which effects reverse over time and which do not.

Comparability work is the second skill. Because finance and operating leases produce different operating income and different operating cash flow under US GAAP, an analyst comparing a US issuer with an IFRS reporter, or two US peers with different lease structures, should recast the operating leases into finance-lease form using disclosed maturities, discount rates and remaining terms before ranking leverage or coverage.