Finance Leasing Manual - FLM10.02

Finance lessees: accountancy treatment: commercial substance

In essence the accounting treatment reflects the commercial substance of the transaction: a finance lease is accounted for in much the same way as a loan.

A finance lease normally consists of two distinct periods: a 'primary' period, and a 'secondary' period. The 'loan' (with 'interest') is repaid during the primary lease period. Once that is over the lessee usually has the option to continue to hire the asset for a nominal rent during the secondary lease period (or periods), either indefinitely or for at least the remaining useful life of the asset.

The structure of the lease is crucial to the nature of a finance lease:

• the primary lease period protects the lessor - it ensures that the loan implied in the lease is repaid just as it would be under an actual loan;

• the secondary lease period protects the lessee - it recognises that the lessee has acquired economic ownership of the asset and that, without legal title to the asset, the lease must protect the lessee's right to carry on using the asset.