What defines a finance lease?

A finance lease is defined by its transfer of all risks and rewards associated with ownership of an asset from the lessor to the lessee. This type of lease typically allows the lessee to utilize the asset for most of its useful life, effectively treating the lease like a purchase for accounting purposes. As a result, the asset is reflected on the lessee's balance sheet, and they recognize both the asset and a corresponding liability to make lease payments. This contrasts with operational leases, where the risks and rewards of ownership remain with the lessor.

For example, under a finance lease, the lessee may be responsible for maintenance, insurance, and any risks associated with the asset's decline in value, similar to true ownership. Thus, the essence of a finance lease is in its financial characteristics, which revolve around control and utilization rather than just the terms or duration of the lease itself.

The other definitions do not capture the critical aspect of risk and reward transfer. Flexible terms relate to operational leases, while short-term leases do not usually transfer ownership risks. Simply not affecting ownership does not address the core nature of a finance lease, which centers around the lessee bearing the financial exposure of the asset.