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Accounting treatment of finance lease example-With Practical Examples
Accounting treatment of a finance lease follows specific guidelines as outlined in international accounting standards such as IFRS 16 (Leases). In a finance lease, the lessee has control of the leased asset for most of its economic life and assumes the risks and rewards of ownership.
Here's a detailed overview:
1.Recognition of the Lease:
At the commencement of the lease term, the lessee should:
Recognize a right-of-use (ROU) asset and a lease liability in its balance sheet.The lease liability is calculated as the present value of future lease payments (discounted using the interest rate implicit in the lease or the lessee’s incremental borrowing rate if the implicit rate is not readily determinable).The ROU asset is measured at the same amount as the lease liability, plus any initial direct costs incurred by the lessee.
2.Initial Measurement:
Right-of-Use Asset (ROU Asset): The ROU asset is initially recognized at cost, which includes:
The initial amount of the lease liability:
* Lease payments made at or before the commencement date (minus any lease incentives).
* Initial direct costs incurred by the lessee.
* An estimate of costs to be incurred in dismantling or removing the asset or restoring the site.
Lease Liability:
The lease liability is recognized at the present value of future lease payments. These payments may include:
Fixed payments.
* Variable payments based on an index or rate.
* Purchase options if the lessee is reasonably certain to exercise the option.
4.Subsequent Measurement:
Right-of-Use Asset:
The ROU asset is subsequently depreciated over the shorter of the lease term or the asset’s useful life. The depreciation is recognized in the income statement.
Lease Liability:
The lease liability is subsequently measured by increasing it to reflect interest on the liability (using the discount rate) and reducing it for lease payments made.
Example of Subsequent Entries:
1.Interest on Lease Liability (to be included in finance costs):
Debit: Finance Cost (Interest Expense)
Credit: Lease Liability
2.Depreciation of ROU Asset:
Debit: Depreciation Expense
Credit: Accumulated Depreciation (ROU Asset)
3.Lease Payments:
Debit: Lease Liability
Credit: Cash/Bank
4.Accounting Treatment - Practical Example:
Suppose Company A enters into a finance lease agreement for a machine for five years. The total future payments are Tk. 1,000,000, with an implicit interest rate of 5%. The present value of the lease payments is Tk. 900,000. Initial direct costs are Tk. 10,000.
At inception, Company A will recognize:
Right-of-Use Asset = Tk. 900,000 + Tk. 10,000 = Tk. 910,000
Lease Liability = Tk. 900,000
During subsequent years:
Depreciation = Tk. 910,000 ÷ 5 years = Tk. 182,000 per year
Interest Expense (on reducing balance) = Tk. Lease Liability × 5%
5.Presentation in Financial Statements:
Statement of Financial Position (Balance Sheet):
Right-of-Use Asset under Non-Current Assets.
Lease Liability split between Current Liabilities and Non-Current Liabilities.
Income Statement:
Depreciation of ROU Asset and interest expense on the lease liability are shown separately.
Cash Flow Statement:
Lease payments are split between interest (financing activity) and principal repayment (financing activity).
6. Key Points to Remember:
Finance lease accounting transfers the risks and rewards of the leased asset to the lessee.
The asset and liability are recognized at the present value of future lease payments.
Depreciation and interest expense are recognized over the lease term.
In Finally:
The accounting treatment of a finance lease impacts both the balance sheet and the income statement through the recognition of assets, liabilities, depreciation, and interest expense. This ensures that the lease transactions are properly accounted for, reflecting the economic substance of the lease agreement.