Accounting Treatment Finance Lease Example

A finance lease, also known as a capital lease, is a type of lease that effectively transfers substantially all the risks and rewards of ownership of an asset from the lessor (the owner) to the lessee (the renter). Under accounting standards (e.g., IFRS 16 or ASC 842), finance leases are treated very differently from operating leases.

Accounting Treatment for Finance Leases

The core principle is that the lessee recognizes the leased asset and a corresponding lease liability on their balance sheet. This reflects that the lessee is essentially financing the purchase of the asset.

Initial Recognition

• Asset (Right-of-Use Asset): The lessee recognizes a right-of-use (ROU) asset. This is initially measured at cost, which comprises:
  • The initial amount of the lease liability.
  • Any initial direct costs incurred by the lessee (e.g., legal fees directly related to the lease).
  • Lease payments made at or before the commencement date, less any lease incentives received.
• Lease Liability: The lessee recognizes a lease liability, which is the present value of the lease payments not yet paid. Lease payments include:
  • Fixed payments (less any lease incentives receivable).
  • Variable lease payments that depend on an index or rate.
  • The exercise price of a purchase option if the lessee is reasonably certain to exercise that option.
  • Payments for penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.
  • Guaranteed residual value.
• The discount rate used to calculate the present value of the lease payments is the interest rate implicit in the lease. If that rate cannot be readily determined, the lessee’s incremental borrowing rate is used.

Subsequent Measurement

• ROU Asset: The ROU asset is typically depreciated over the shorter of the asset’s useful life or the lease term. The depreciation method should be consistent with how the lessee depreciates its other similar assets. The asset is also tested for impairment if indicators of impairment exist.
• Lease Liability: The lease liability is subsequently measured using the effective interest method. Interest expense is recognized each period, increasing the lease liability. Cash payments decrease the lease liability.

Finance Lease Example

Company A enters into a 5-year lease for a machine with an estimated useful life of 7 years. The annual lease payments are $20,000, payable at the beginning of each year. At the end of the lease term, ownership of the machine transfers to Company A. The interest rate implicit in the lease is 6%.

Initial Recognition

1. Present Value Calculation: Calculate the present value of the lease payments using the 6% discount rate. Since the payments are made at the beginning of each year, it’s an annuity due calculation. The present value of the lease payments is approximately $84,247.
2. Journal Entry: * Debit: ROU Asset: $84,247 * Credit: Lease Liability: $84,247

Subsequent Measurement (Year 1)

1. Depreciation Expense: Depreciate the ROU asset over its useful life (7 years, since ownership transfers). Depreciation expense is $84,247 / 7 = $12,035.
2. Interest Expense: At the beginning of year 1, Company A makes the first lease payment of $20,000. The Lease Liability is reduced by $20,000. The interest expense for year 1 is calculated on the remaining lease liability of $64,247 ($84,247-$20,000). The interest expense would be $64,247 * 6% = $3,855.
3. Journal Entries: * Debit: Depreciation Expense: $12,035 * Credit: Accumulated Depreciation: $12,035 * Debit: Interest Expense: $3,855 * Credit: Lease Liability: $3,855 *Debit: Lease Liability: $20,000 *Credit: Cash: $20,000

This process continues each year, with the ROU asset being depreciated and the lease liability being reduced by lease payments and increased by the interest expense. Because ownership transfers, it is treated as a finance lease. If ownership did *not* transfer, and other criteria were also not met, it would likely be treated as an operating lease.