Finance Leases (for a Lessee)
Lesson:
A finance lease is like a purchase made with yearly (or monthly, or weekly) payments.
When the lease begins, the lessee books an asset representing his right to use an asset, and a liability for the present value of the lease.
Every period, the lessee pays the lessor a fixed amount of money. The longer on in the lease, the more will go to pay off the principal with the rest going to interest.
You've just been hired as a CFO and are trying to make sense of the firm's financials.
The only relevant information you've discovered is as follows:
- The present value of the lease payments is $5,666.80.
- The lessee's incremental borrowing interest rate is 7%.
- The lessor's implicit interest rate is 6%.
- The yearly required payment is $2,000.
- The lease is an annuity due.
What is the final year's journal entries that the lessee must record?
Answer:
- The final year's journal entries are as follows:
Lease Accounting Journal - Entries for year 3 Lease Liability $2,000.00 Cash $2,000.00 Interest Expense $113.21 Lease Liability $113.21 Amortization Expense $1,888.93 Right-of-use Asset $1,888.93
Explanation:
- First, we need to figure out which interest rate to use. Always use the lessor's implicit interest rate. If it's not available, use the lessee's incremental borrowing rate
INTEREST RATE = 6% - Now let's build an effective interest table. If you're unsure how to do this, we have an entire exercise on building effective interest tables.
Year Lease Payment Interest Lease Reduction Lease Liability Lease Initiation $0.00 $0.00 $0.00 $5,666.80 Start of year #1 $2,000.00 $0.00 $2,000.00 $3,666.80 Start of year #2 $2,000.00 $220.01 $1,779.99 $1,886.81 Start of year #3 $2,000.02 $113.21 $1,886.81 $0.00 - Before we do anything else, we need to book the asset and liability generated by this lease. Our asset will be the right-of-use for the asset, and the liability will be the money we owe on the lease.
Lease Accounting Journal - Initial Entries Right-of-Use Asset $5,666.80 Lease Liability $5,666.80 - Let's account for the lease payment. We can grab this number directly from the facts presented or from our effective interest table. Since we are paying off the asset with cash, we'll credit the lease liability.
Lease Accounting Journal - Entries for year 1 Lease Liability $2,000.00 Cash $2,000.00 - We also need to account for the extra interest expense from this year. All of that interest that we have to pay gets tacked on to our lease liability.
Lease Accounting Journal - Entries for year 1 Lease Liability $2,000.00 Cash $2,000.00 Interest Expense $0.00 Lease Liability $0.00 - We need to figure out the yearly amortization expense.
AMMORTIZATION EXPENSE = PRESENT VALUE OF INIITIAL LEASE LIABILITY / NUMBER OF YEARS IN THE ENTIRE LEASE - Plugging in the numbers, we see:
$1,889 = $5,667 / 3 - Let's record the changes to amortization expense and right-of-use asset.
Lease Accounting Journal - Entries for year 1 Lease Liability $2,000.00 Cash $2,000.00 Interest Expense $0.00 Lease Liability $0.00 Amortization Expense $1,888.93 Right-of-use Asset $1,888.93 - Since we have not yet paid off the loan, we have to repeat the process starting from entering a lease payment.
- Let's account for the lease payment. We can grab this number directly from the facts presented or from our effective interest table. Since we are paying off the asset with cash, we'll credit the lease liability.
Lease Accounting Journal - Entries for year 2 Lease Liability $2,000.00 Cash $2,000.00 - We also need to account for the extra interest expense from this year. All of that interest that we have to pay gets tacked on to our lease liability.
Lease Accounting Journal - Entries for year 2 Lease Liability $2,000.00 Cash $2,000.00 Interest Expense $220.01 Lease Liability $220.01 - We need to figure out the yearly amortization expense.
AMMORTIZATION EXPENSE = PRESENT VALUE OF INIITIAL LEASE LIABILITY / NUMBER OF YEARS IN THE ENTIRE LEASE - Plugging in the numbers, we see:
$1,889 = $5,667 / 3 - Let's record the changes to amortization expense and right-of-use asset.
Lease Accounting Journal - Entries for year 2 Lease Liability $2,000.00 Cash $2,000.00 Interest Expense $220.01 Lease Liability $220.01 Amortization Expense $1,888.93 Right-of-use Asset $1,888.93 - Since we have not yet paid off the loan, we have to repeat the process starting from entering a lease payment.
- Let's account for the lease payment. We can grab this number directly from the facts presented or from our effective interest table. Since we are paying off the asset with cash, we'll credit the lease liability.
Lease Accounting Journal - Entries for year 3 Lease Liability $2,000.00 Cash $2,000.00 - We also need to account for the extra interest expense from this year. All of that interest that we have to pay gets tacked on to our lease liability.
Lease Accounting Journal - Entries for year 3 Lease Liability $2,000.00 Cash $2,000.00 Interest Expense $113.21 Lease Liability $113.21 - We need to figure out the yearly amortization expense.
AMMORTIZATION EXPENSE = PRESENT VALUE OF INIITIAL LEASE LIABILITY / NUMBER OF YEARS IN THE ENTIRE LEASE - Plugging in the numbers, we see:
$1,889 = $5,667 / 3 - Let's record the changes to amortization expense and right-of-use asset.
Lease Accounting Journal - Entries for year 3 Lease Liability $2,000.00 Cash $2,000.00 Interest Expense $113.21 Lease Liability $113.21 Amortization Expense $1,888.93 Right-of-use Asset $1,888.93 - Since we have not yet paid off the loan, we have to repeat the process starting from entering a lease payment.