What is a finance lease?
A finance lease is a lease under which the lessee in practice obtains the economic benefits and risks of owning an asset, without owning it legally. The lessee obtains the right to use the asset over a major part of its economic life in exchange for periodic lease payments. At the end of the lease term, the lessee can often buy the asset at a reduced price, extend the lease or return the asset to the lessor. Typical assets under finance leases include machinery, vehicles, buildings and IT equipment.
A finance lease differs from an operating lease, under which substantially all the risks and rewards of ownership are not transferred to the lessee. The lease term is then often shorter than the asset’s economic life. Finance leases are often used to fund larger investments such as vehicles, machinery and equipment, where the cost is to be spread over time.
Accounting for finance leases
Understanding and correctly accounting for finance leases is essential for accurate financial reporting, regulatory compliance, clear communication with investors and a sound credit standing. It matters for several reasons:
- Regulatory compliance: Different countries have different accounting rules for finance leases. For companies operating internationally, it is important to comply with the relevant standards, such as NRS 14 in Norway, K3 in Sweden, the rules for reporting class C in Denmark and IFRS 16 for companies reporting under IFRS.
- Financial reporting: Finance leases have a significant effect on the balance sheet and the income statement. Correct accounting ensures that the company’s financial position is presented accurately and gives a true picture of its assets and liabilities.
- Tax: The tax treatment of leases follows the tax rules and is not necessarily the same as the accounting treatment. Differences between accounting and tax must be tracked, for example when calculating deferred tax.
- Investor communication: Investors and other stakeholders need accurate information about the company’s obligations and assets. Clear and correct accounting for finance leases supports better decisions and investor confidence.
- Financing and credit rating: Finance leases affect key ratios such as gearing and equity ratio, which in turn can affect the company’s access to finance. Understanding how leases affect these ratios is essential for financial planning and management.
Who must apply which rules?
Companies whose securities are admitted to trading on a regulated market in the EU/EEA must prepare their consolidated financial statements in accordance with IFRS (Regulation (EC) No 1606/2002, Article 4), and therefore apply IFRS 16. In Norway, this also covers companies that only have listed debt securities, for example bonds on Oslo Børs. Other companies follow national accounting rules, under which finance leases must be recognised in the balance sheet.
In Norway, small enterprises may nevertheless choose not to recognise leases in the balance sheet (Norwegian Accounting Act, section 5-11; NRS 14, paragraph 69). An enterprise is no longer a small enterprise when, at the balance sheet date, it exceeds at least two of these three thresholds (section 1-5):
- Balance sheet total: NOK 84 million
- Sales revenue: NOK 168 million
- Average number of employees: 50 full-time equivalents
A change of size category takes effect only from the second of two consecutive financial years in which the thresholds are exceeded.
Finance leases under NRS 14
NRS 14 is the Norwegian accounting standard that regulates the accounting for leases. It applies to the lessee (NRS 14, paragraph 7) and covers both operating and finance leases.
The main purpose of NRS 14 is to ensure that lease obligations and rights are correctly reflected in the company’s financial statements, and that users of the financial statements get a true and fair view of the company’s financial position.
NRS 14 requirements for finance leases
Under NRS 14, a finance lease is recognised as both an asset and a liability in the balance sheet at the start of the lease term. This reflects that the lessee in practice has the economic risks and rewards of owning the leased asset.
Read also: Calculations according to IFRS 16
Key requirements for finance leases under NRS 14:
- Initial recognition: At the start of the lease, the asset and the liability are recognised at the present value of the lease payments. The present value is calculated using either the interest rate implicit in the lease or the lessee’s incremental borrowing rate (NRS 14, paragraph 29).
- Depreciation: The asset is depreciated over the estimated lease term, or over its economic life if that is shorter. If it is reasonably certain at the inception of the lease that the lessee will buy the asset, it is depreciated over its expected economic life (NRS 14, paragraph 35).
- Interest expense: Lease payments are split between interest expense and a reduction of the outstanding liability. Interest expense is recognised in profit or loss over the lease term and is calculated using the effective interest method.
- Changes in estimates: The depreciation plan is reassessed at the end of each reporting period (NRS 14, paragraph 55). A change in market interest rates does not require the lease liability to be remeasured (NRS 14, paragraphs 57–58).
How to classify a lease as a finance lease
Under NRS 14, a lease is classified as a finance lease if one of the following criteria is met (NRS 14, paragraph 26):
- Purchase option: The lessee has the right to buy the leased asset at a price expected to be significantly lower than its market value at the date the right can be exercised, so that it is reasonably certain at the inception of the lease that the lessee will buy it.
- Lease term: The estimated lease term covers the major part of the asset’s economic life, even if ownership is not transferred.
- Present value of lease payments: The present value of the estimated lease payments substantially equals the market value of the leased asset at the inception of the lease.
- Specialised asset: The leased asset is of such a specialised nature that it cannot be used by anyone other than the lessee without major changes or modifications.
A lease that contains both a right and an obligation to buy the leased asset at the end of the lease term is treated as an instalment purchase for accounting purposes and falls outside NRS 14 (paragraph 4). Under IFRS 16, transfer of ownership by the end of the lease term is one of the examples that normally lead the lessor to classify a lease as a finance lease (IFRS 16.63(a)).
Examples of accounting for a finance lease under NRS 14
Initial recognition
A company enters into a finance lease for a machine with a lease term of five years. The present value of the future lease payments is EUR 500,000, and the machine’s economic life is seven years. At the start of the lease, the company recognises:
- Asset (production equipment): EUR 500,000
- Liability (lease liability): EUR 500,000
Annual depreciation
The production equipment is depreciated over the five-year lease term, because the lease term is shorter than the economic life and it is not reasonably certain that the company will buy the machine. Annual depreciation is therefore: EUR 500,000 / 5 years = EUR 100,000
Interest expense and reduction of the liability
Assume that the annual lease payment is EUR 115,487, paid at the end of each year, and that the interest rate is 5%. The interest expense for the first year is then:
- Interest expense, year 1: EUR 500,000 × 5% = EUR 25,000
- Reduction of the lease liability: EUR 115,487 – EUR 25,000 = EUR 90,487
At the end of the first year, the amounts are:
- Interest expense: EUR 25,000
- Reduction of the liability: EUR 90,487
- Lease liability at year end: EUR 500,000 – EUR 90,487 = EUR 409,513
Applying NRS 14 correctly ensures that the financial statements reflect the economic reality of finance leases, which supports sound financial management and stakeholder confidence.
Finance leases under IFRS 16
IFRS 16 and national accounting rules for finance leases all regulate the accounting for leases, but there are important differences. IFRS 16 applies to all companies that report under International Financial Reporting Standards (IFRS). For the lessee, all leases are accounted for using the same model, whether they would previously have been classified as operating or finance leases. The lessor must still classify each lease as either an operating lease or a finance lease (IFRS 16.61).
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset (IFRS 16.62). The term is used both in national accounting standards, such as NRS 14 in Norway, K3 in Sweden and the rules for reporting class C in Denmark, and in IFRS 16, where it applies to the lessor’s classification (IFRS 16.61–66).
Differences in lease classification
IFRS 16, which applies to annual reporting periods beginning on or after 1 January 2019 (IFRS 16.C1), removed the distinction between operating and finance leases for lessees. The lessee recognises a right-of-use asset and a lease liability for all leases (IFRS 16.22), but may exempt short-term leases and leases for which the underlying asset is of low value (IFRS 16.5). In profit or loss, the lessee recognises depreciation of the right-of-use asset and interest expense on the lease liability. Under national standards such as NRS 14, K3 and the rules for reporting class C, the distinction between operating and finance leases is retained.
For the lessor, the distinction also remains under IFRS 16. In a finance lease, the lessor recognises a receivable at an amount equal to the net investment in the lease instead of the underlying asset (IFRS 16.67). In an operating lease, the lessor keeps the underlying asset and recognises the lease payments as income on a straight-line basis or another systematic basis (IFRS 16.81).
Under national rules, finance leases must be recognised in the balance sheet, both the asset and the liability, while operating leases normally only require disclosure in the notes. Operating leases are therefore normally expensed as lease costs over the lease term, while finance leases are recognised in the balance sheet.
IFRS 16 requires extensive note disclosures about lease terms, future lease payments and how leases affect the company’s financial position and performance. This includes details of lease liabilities, right-of-use assets and the related depreciation and interest expense. NRS 14 also requires note disclosures for finance leases, including the recognised leases and the maturity of the remaining lease payments (NRS 14, paragraphs 60–61). Under national standards such as NRS 14, K3 and the rules for reporting class C, the disclosure requirements may be less extensive than under IFRS 16.
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Recognising leases in the balance sheet
Operating leases
Under traditional national accounting standards, such as NRS 14 in Norway, K3 in Sweden and the rules for reporting class C in Denmark, operating leases are treated differently from finance leases. Operating leases are leases under which the risks and rewards of ownership are not substantially transferred to the lessee. These leases are not recognised in the balance sheet; instead, the lease payments are expensed in the income statement as lease costs over the lease term. The company therefore does not recognise the leased asset or the liability in the balance sheet, which can affect its gearing and capital structure.
After the implementation of IFRS 16, however, there has been a significant change in how operating leases are treated by companies that are required to report under IFRS. IFRS 16 removes the distinction between operating and finance leases for lessees. All leases must now be recognised in the balance sheet, but short-term leases and leases for which the underlying asset is of low value can be exempted (IFRS 16.5). The company recognises a right-of-use asset and a corresponding lease liability at the commencement date. The expense then consists of depreciation of the right-of-use asset and interest expense on the lease liability. This change can lead to a significant increase in both assets and liabilities in the balance sheet for many companies, as well as changes in key ratios such as EBITDA and gearing.
Finance leases
Finance leases are leases under which substantially all the risks and rewards of ownership are transferred to the lessee. The lessee recognises these leases in the balance sheet both under national rules (except small enterprises that use the exemption in section 5-11 of the Norwegian Accounting Act) and under IFRS 16. Under IFRS 16, the lessor in a finance lease recognises a receivable equal to the net investment in the lease instead of the underlying asset (IFRS 16.67).
Under NRS 14, the following applies to the lessee:
- Initial recognition: At the start of a finance lease, the lessee recognises the asset and the liability at the present value of the lease payments, discounted at the interest rate implicit in the lease or the lessee’s incremental borrowing rate (NRS 14, paragraph 29).
- Depreciation: The recognised asset is depreciated over the estimated lease term, or over its economic life if that is shorter (NRS 14, paragraph 35).
- Interest expense: The lease payments are split into interest expense and a reduction of the lease liability. Interest expense is calculated using the effective interest method.
Example of a finance lease
- Initial recognition: For a lease with annual lease payments of EUR 200,000 over five years, paid at the end of each year, and a discount rate of 5%, the present value of the future lease payments is approximately EUR 865,900. This amount is recognised as both an asset and a liability.
- First-year accounting: The asset is depreciated by EUR 173,180 per year (EUR 865,900 / 5), and the interest expense for the first year is EUR 43,295 (5% of EUR 865,900). Of the lease payment of EUR 200,000, EUR 43,295 is interest and EUR 156,705 reduces the liability.
Keep track of your leases with ShareControl IFRS 16
ShareControl IFRS 16 is a specialised solution that helps companies meet the requirements of IFRS 16 for lease accounting. The system simplifies identifying, registering and reporting leases, which can otherwise be a complex and time-consuming task.
The system automates the recognition of right-of-use assets and the related lease liabilities. It calculates the present value of future lease payments and generates the accounting journal, which reduces the risk of errors and saves time. ShareControl IFRS 16 helps companies classify leases correctly as either operating or finance leases, in line with national accounting standards (such as NRS 14, K3 and the rules for reporting class C) and IFRS 16.
ShareControl IFRS 16 handles leases efficiently and supports correct accounting under IFRS 16 and the national rules for finance leases. This frees up time and resources, so finance staff can focus more on strategic tasks that contribute to the company’s growth.
