Interest expense is a type of expense that the lessee of a finance lease must account for. These types of leases typically involve the transfer of ownership at the end of the lease term, and the lessee’s interest on the loan is classified as lease interest expense. Examples of finance leases include vehicle and equipment leases.
Finance lease interest expense is recorded in the operating segment of the income statement, below Income from Operations. This expense is accounted for in the same way as depreciation expense. On the other hand, for operating leases, the difference between cash payments and the amount of reduction in the lease liability is recorded as lease expense.
The amount of finance lease interest expense varies, and the amount depends on the type of lease. For example, if you are leasing a car, the accounting expense for interest on a finance lease is equal to the cost of leasing the car. In the example below, the total cost of the lease is $515,000, which is the nondiscounted sum of ten lease payments of $50,000 each, plus an initial direct cost of $15,000, or $51,500 per year.
Financial statements can be a useful tool to evaluate finance leases, but underlying financial statements can have inaccurate or incomplete information. Because of this, the FASB began researching how to properly account for leases, ensuring that they are transparent and useful to both the lessee. In February 2015, FASB released Accounting Standards Update 2016-02, which amends FASB Accounting Standards Codification Topic 842. The purpose of this update is to make financial reporting of lease transactions more meaningful for businesses.
Finance lease accounting is similar to capital lease accounting. Once a firm enters a finance lease, it will record a right-of-use asset and a lease liability. The right-of-use asset will be amortized over the life of the lease, and the lease liability will be amortized using the effective interest method. Both of these expenses will be separately presented on the income statement.
As with any other lease liability, finance lease interest expense should not be confused with depreciation expense. In contrast, depreciation expense is a type of expense that can be categorized as an operating expense. Under ASC 840, the lessee should record the leasing liability as a lease liability.
If the lessee enters a finance lease, it must be aware that the payments will be substantially more than 90% of the underlying asset. This rate is typically not stated in the contract. Therefore, it must be estimated based on certain inputs from the lease contract. There are various formulas used to estimate the implicit rate of a lease.
Converting operating lease expenses to finance lease expense should not have a significant impact on the valuation of a firm. It will not change the free cash flow to equity. However, the change in present value of operating leases will increase the firm’s net capital expenditure.