Examples of Finance Lease

Examples of Finance Lease

The lease can be classified as finance lease if risks and rewards associated with asset are transferred to lessee. The associated risks may classify into repairing cost, insurance costs, maintenance cost and risk of obsolescence. The rewards are the maximum economic benefit is utilized by the lessee and use without any limitation.

Example # 1 Finance lease and Repair Cost

ABC Company took an asset on lease for 2 years the economic life of the asset is 10 years. Repair and maintenance is responsibility of lesser. Classify lease type?

In above case lessee is using only 20% of economic life of the asset therefore the reward associated with asset remains with lesser , moreover , repair cost also responsibility of lesser that means that risks associated with asset is also not transferred to lessee, Therefore this lease is operating lease.

Example # 2 Finance Lease and obsolescence

ABC Company enters with a contract with XYZ Company to lessee a plant and machinery for 6 years having useful life of 8 years. ABC may return the asset any time due to obsolescence.

In above example although company is using the maximum economic life of the asset i.e. reward, however, risk remain with the lesser as asset can be returned any time, therefore this lease is operating lease.

Example # 3 Finance lease and buy option

ABC Co took a plant from XYZ at cost of $ 2 million; the plant has useful life of 3 years but can be use for further 3 years with some modification and repair expenditure of $.5. XYZ require the return of asset at the end of 3 year and no buy option is available.

This lease does not carry the buy option and reward associated at the end of useful life is not transferred to lessee therefore this is operating lease.

Example # 4 Finance lease and cancellation

ABC Company takes machinery on lease from Raheel & Co for 5 year (useful life 5 year). The lease contract has option of cancellation option by the lesser any time.

In this example the rewards are not fully transferred to the lessee i.e. can be cancelled any time, Therefore this is an operating lease.