What Is a Finance Lease?
A finance lease is economically closer to buying an asset with borrowed money than to renting it. Even though legal title may stay with the lessor, the lessee gets essentially all the value the asset will ever produce and bears the risks of ownership. Long-term leases of manufacturing equipment, vehicles, and specialized machinery are frequently structured this way.
Under ASC 842, a lease is classified as a finance lease if it meets any one of five criteria: ownership transfers at the end of the term, the lessee holds a purchase option it is reasonably certain to exercise, the term covers a major part of the asset's economic life (commonly benchmarked at 75%), the present value of payments equals substantially all of the asset's fair value (commonly 90%), or the asset is so specialized it has no alternative use to the lessor.
How Finance Lease Accounting Works
At commencement, the lessee records a right-of-use asset and a lease liability equal to the present value of the lease payments, the same starting point as an operating lease. The difference is in subsequent expense recognition. The ROU asset is amortized on a straight-line basis, typically within operating expenses, while the liability accrues interest that flows through interest expense below operating income.
This split creates a front-loaded total expense pattern, since interest is highest when the liability balance is largest. It also changes the cash flow statement: the principal portion of lease payments appears in financing activities while only the interest portion touches operating cash flow, which flatters operating cash flow relative to an identical operating lease. IFRS 16 applies this treatment to virtually all leases, which is why EBITDA is not directly comparable across GAAP and IFRS filers.
Why Classification Matters
Because amortization and interest sit below the EBITDA line, a company with finance leases reports higher EBITDA than an identical company expensing operating lease rent, even though the underlying cash payments are the same. Credit analysts treat finance lease liabilities as debt in leverage ratios, and equity analysts must include them in enterprise value to keep EV/EBITDA multiples consistent.
For interview preparation, the classic question is to compare operating and finance lease treatment and trace the effects through the financial statements. A strong answer covers the shared balance sheet mechanics under ASC 842, the diverging income statement geography, the cash flow statement split, and the resulting distortions in EBITDA and leverage metrics that analysts adjust for in comps.
