Accounting for Finance Leases by the Lessee

Introduction

A Finance Lease or Capital Lease is often incorrectly disclosed and treated in the financial statements. This tutorial will focus on how to practically incorporate the principles of accounting for finance leases in the financial statement of the lessee.

As covered recently in our ‘Path of Lease Resistance’ post, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) of the United States recently published for public comment a proposal to change the way that leases are accounted for. Under the proposal, a ‘right-of-use’ approach will be adopted for lease accounting.

In over 100 countries that govern accounting using International Financial Reporting Standards, the controlling standard is IAS 17 “Leases”. Based on IAS 17, the following principles should be applied in the financial statements of lessees

• IAS 17.20
  At commencement of the lease term, finance leases should be recorded as an asset and a liability at the fair value of the asset and the present value of the minimum lease payments.
• IAS 17.25
  Finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability (the finance charge to be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability).
• IAS 17.27
  The depreciation policy for assets held under finance leases should be consistent with that for owned assets. If there is no reasonable certainty that the lessee will obtain ownership at the end of the lease – the asset should be depreciated over the shorter of the lease term or the life of the asset.

To see how these changes may impact your project or company, this tutorial will show you how to incorporate the above principles into your financial model. Download our Excel workbook and read this tutorial for a step-by-step approach on this topic.

Most leases will be recognised as assets and liabilities on the balance sheet, which is similar to the present treatment of finance leases or capital leases. 

The assumption page

The first step in financial modelling is to build a user-friendly and flexible input section. Refer to Screenshot 1 for the layout of assumptions for the finance lease used in our sample worksheet.

• Lease commences in 31-Dec-10
• Fair value of the leased asset is USD 250 million
• Lease term is 10 years
• The implied lease rate for the purpose of calculating the finance charge is 12.50% p.a.
• In addition to the lease payments, there are executory costs, i.e. rates and maintenance to be paid by the lessee during the lease term
• The leased asset is depreciated using the Straight Line method in line with the depreciation policy of the company. The asset life is assumed to be similar to the lease term, i.e. 10 years

Screenshot 1: Assumptions for Finance Lease

Finance Lease calculation

Calculate finance lease payments

As indicated earlier, finance lease payments should be apportioned between the finance charge (interest portion) and the reduction of the outstanding liability (principal portion). The interest portion will be expensed while the principal portion will reduce the lease obligation in the balance sheet over the lease term.

Finance lease payments can be calculated in a similar way to an annuity (credit foncier) repayment of your debt facility. Refer to Screenshot 2 for lease payment calculation in this example.

Screenshot 2: Calculate Finance Lease payments

Calculate the executory expenses

The calculation of these costs is relatively simple and is treated in a similar manner to the operating costs. Refer to Screenshot 3.

Screenshot 3: Calculate the executory expenses

Calculate the depreciation

To calculate depreciation, refer to our previous tutorial ‘Straight line depreciation with reverse ticker’.

Learn how to build a full set of integrated financial statements, and how to balance and check the balance sheet in the Project Finance Modelling B course. 

Accounting and the Financial Statement

Journal entries

The journal entries for finance lease are depicted below

To record the leased asset and leased liability at the inception of the lease term

Dr Leased Asset
           Cr Leased Liability

To record the lease depreciation charge at the end of each period during the life of asset

Dr Depreciation Charge
            Cr Accumulated Depreciation

To record the finance lease payments during the lease term

Dr Leased Liability
Dr Interest Expense
             Cr Cash

To record the executory expenses during the lease term

Dr Executory Expenses
              Cr Cash

Financial statement

How will the financial statements look after incorporating the above journal entries? The screenshots below show extracts of the financial statements, highlighting the journal entries of the finance leases for the Balance Sheet, Profit and Loss and Cashflow Waterfall.

Screenshot 4: Balance Sheet

Screenshot 5: Profit & Loss

Screenshot 6: Cashflow Waterfall

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