In essence, a finance lease is equivalent to the purchase of an asset that is financed with debt.
For lessor, a finance lease can be treated as either a sales-type lease, or a direct financing lease (US GAAP only).
At inception, a lease receivable, equal to the present value of the lease payments, is created in the lessor’s balance sheet.
The asset is brought over to the lessee’s balance sheet as a “right-of-use” asset. A liability of equal amount is also recognised to account for the lease payments to be made for the asset.
Over the term of the lease, the right-of-use” asset is depreciated. Depreciation expense, as well as interest expense, is reported in the lessee’s income statement.
As the lease payments are received by the lessor, the principal portion of the payment reduces the lease receivable. It does not add to the current period income.
The interest portion received is reported in the lessor’s income statement as interest income.
See Lease classification criteria on determining if a lease is a finance lease or operating lease.
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