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CA Intermediate · Financial Management and Strategic Management · Types of Financing

A firm obtains machinery on a finance lease from a lessor under which the firm bears maintenance and insurance, and the lease term covers most of the asset's economic life. Which description best fits this arrangement in the context of long-term financing?

The arrangement is a finance lease, because the lessee bears maintenance and insurance and the lease runs for most of the asset's economic life. These features show that substantially all risks and rewards of ownership have passed to the lessee, unlike an operating lease.

  1. AThe lessee bears substantially all risks and rewards of ownership, so the lease is a finance leaseCorrect
  2. BThe lessor bears maintenance, so the lease is an operating lease
  3. CThe lease is a sale and leaseback by definition
  4. DThe lease is a hire purchase because ownership passes automatically

Explanation

A finance lease transfers substantially all risks and rewards incidental to ownership to the lessee. Lease term covering most of the economic life and the lessee bearing maintenance and insurance indicate this. In an operating lease the lessor usually bears maintenance, which is not the case here.

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