Accounting for Leases

A lease is an arrangement in which one party, called the lessor, provides an asset for use of the other party, called the lessee, against periodic payments for a specified time period.

Accounting for leases depends on the terms and conditions of the lease i.e. whether it is a finance lease or an operating lease.

Types of Leases

A lease is either:

Other classifications include: sales-type lease and direct financing lease.

Substance-over-form principle is applied to determine whether risks and rewards have transferred or not; which means that transfer of legal ownership is not very relevant in deciding whether a lease is an operating lease or a finance lease.

Since a finance lease involves transfer of risk and rewards, the leased asset is recorded in the books of the lessee together with a corresponding lease liability. The leased asset is recorded at the present value of minimum lease payments (or fair value if it is lower). The present value of minimum lease payments is determined using the rate of interest implicit in the lease (or the lessee’s incremental rate of return if the interest rate implicit in the lease is not available).

Finance Lease: Example

PMA, Inc. is a rail company which has leased out diesel generators from GP, Ltd. to provide backup to the transportation system during power outages. The lease has 5-year term in which PMA has to make $500,000 payment to GP at the end of each year. Journalize the inception of the lease and the first payment made by PMA in the books of the PMA and GP if PV of minimum lease payments is $1,996,355 and rate of interest implicit in the lease is 8%.

Journalize the transactions in the books of the lessor and lessee if it meets the recognition criteria of a finance lease.

Books of lessor

The lessor shall record the start of a lease by creating a lease receivable at its net investment in lease, which is equal to the minimum lease payments discounted at the rate of interest implicit in the lease.

Journal entry posted at the start of the lease contract:

Lease receivable1,996,355
Asset1,996,355

At the time of first payment, lessor shall record receipt of cash, reduction in lease receivable and recognition of finance income:

Cash500,000
Lease receivable (500,000-40,000)460,000
Finance income (500,000×8%)40,000

The reduction in lease receivable reduces the principal balance in lease receivable to $1,536,355, which shall reduce the next year finance income.

Books of lessee

A finance lease results in recognition of both an asset and a liability in the books of the lessee at the inception of the lease at amount equal to present value of minimum lease payments.

Leased asset1,996,355
Lease liability1,996,355

It is quite possible that the lease asset and lease liability are recorded at the different amounts in the books of lessor and lessee.

At the time of first annual payment, lessee records the following journal entry:

Lease liability460,000
Interest expense ($500,000*8%)40,000
Cash500,000

At the end of first year, the lessee shall post one additional entry to recognize the depreciation expense on the leased asset. It depreciates the leased asset as if it is an owned asset.

Accounting for operating leases is pretty straightforward because they do not involve recognition of any asset or liability. The lease income is recognized on a basis reflecting the use of the asset.

Operating Lease: Example

Refer to example above for finance lease. Journalize the transactions in the books of lessor and lessee if the lease meets the criteria for recognition as an operating lease instead of a finance lease.

Books of lessor

No journal entry shall be made the start of the lease contract.

During the first year, the lessor shall recognize receipt of lease rental as follows:

Cash500,000
Lease rental income500,000

Books of lessee

No journal entry shall be made at the start of the lease. At the time of first payment, the following journal entry is required:

Lease expense 500,000
Cash 500,000

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork