This paragraph gives a very brief outline of the accounting
background as a reminder of the salient points for those who have
previous knowledge of the accountancy. Newcomers to finance lease
accounting should read the relevant parts of the Finance Leasing
Manual (FLM2.01 onwards) before looking at subsequent paragraphs in
this manual.
GAAP divides leases into two categories,
‘finance’ leases and ‘operating’ leases. A
lease for this purpose is any hiring of an asset, including an
agreement described as a licence for the use of rights derived from
an intangible asset.
A lease is treated as a finance lease for accounting purposes
if it is one which transfers substantially all the risks and
rewards of ownership of an asset from the lessor to the lessee. A
finance lease is accounted for as a loan from lessor to lessee to
fund the acquisition of the leased asset by the lessee.
The amount regarded as the loan appears as an asset in the
balance sheet of the finance lessor and rental receipts are treated
partly as repayment of that loan and partly as interest on it.
Conversely, the lessee treats the amount regarded as a loan as a
liability and records a similar amount as the value of the leased
asset on the other side of the balance sheet. Rentals are again
split into interest and repayments of principal while the asset is
depreciated in the same way as other assets which the lessee
legally owns.
A lease which is not a finance lease is classed an operating
lease. Rentals paid and received are simply taken to the profit and
loss account as the expense/income accrues which is not necessarily
when rentals are paid/received.
A hire purchase contract (which is simply a lease where the
lessee has an option to purchase the legal title of the asset on
fulfilment of the conditions in the contract, normally the making
of an agreed number of payments) is accounted for as a lease. Most
hire purchase contracts will be regarded as finance leases.
