How to Account for a Finance Lease (Lessee’s Perspective) #Finance

in this CashNews.co We’re going to discuss How to account for a Finance lease from the perspective of the less so the first thing You’re going to do is You’re going

to book a right of use asset to record the property that you’re leasing and then You’re going to recognize the liability for the lease payments that you’re obligated to make then over time You’re going to recognize amortization expense and You’re slowly going to reduce

the value of this right of use asset but You’re also going to be increasing The liability as interest accs and not actually paying interest expense to less or but We’re going to make an effective interest Table And We’re going to recognize some interest expense and then as you

make the lease payments to the less or You’re going to reduce the lease liability ultimately to zero So I want to walk you through An example it’ll make it a little bit easier to understand so Let’s say that your Company leases a Truck and They have a 3ye lease agreement and the

Truck is expected to have a a residual value of $15,000 at the end of the the lease in 3 years um Now That value can be guaranteed or ungar and that actually matters And we’ll talk about that in Future CashNews.cos Why That’s important But for Right now Let’s just say Hey

There’s a residual value of $15,000 We won’t get too much into the details Right now your Company is going to make lease payments of $220,000 at The Beginning of each Year because it’s a three-year lease that means You’re going to make a $220,000 payment on day one and then

The Beginning of the next two Years they’re going to make $20,000 payments so there’ll be a Total of three payments of $20,000 and we can go and say well What is the present value of those payments What’s the present value of this residual value and so forth Ok Now what we need to

do we need to be able to do discounting and so We’re going to need to know the less or implicit interest rate which in this case we’ll say It’s 6 If You didn’t know what the less implicit interest rate was then you would use your own incr mental borrowing rate but here

We’re going to say we know the less rate and 6 So We can use that to discount this 15,000 That’s that we assume the value will be in 3 years we’ll say Ok we’ll discount that back to the present value and so That’s 12,54 and then the present value of the lease payments

That’s actually An annuity due and so we’d use the annuity Du Formula and that would be a present value the lease payments of 56,000 $68 Now If WE add those two Together the present value of the residual value and the present value of the lease payments that equals the Fair value of

this Truck Okay So now Let’s let’s get a little more into details Let’s put this defective interest table Together and start seeing how this lease liability would be reduced over time so what We’re going to start with is this 5,668 We’re not including the residual

value in our least liability ok So we’ve got 56,68 That’s What we start with on day one ok January 1 2017 but also on day one we do something else we make the first lease payment cuz remember We said these are payments are made At The Beginning of each Year so day one we make a $220,000

lease payment and That’s going to reduce That’s going to reduce the least liability by $20,000 so immediately we go from 56 668 to 30 6668 of the least liability now after one year ok So when we get to January 1 2018 there has now been one year of interest that has accrued on the

liability so We Take The 36,68 We multiply it by 06 to reflect that 6 per implicit interest rate a less or that gives us $2200 Ok Now The $2,200 is going to increase the lease liability However on January 1 2018 We also make a lease payment and the lease payment is going to decrease the least

liability so We net these two amounts Together Ok and when we net them Together What We see is There’s going to be a reduction in the least liability of $7,800 Ok and so we go 36,68 Which is our previous leas liability reduce that by 1,800 That’s going to give us 18,86 remaining least

liability We then for the for the next period for January 1 Now we say Ok There’s now been another year of interest right so We say 18,68 and then We multiply that by6 that gives us 11,32 and we have a We have a lease payment of $220,000 If WE net these two Together then We get 18,68

reduction in the least liability 18,68 Min 18,000 868 Is Zero so We No longer have any lease liability because we’ve we’ve made all our lease payments We’re all set Ok Now it’s not going to be exactly the same if you had An operating lease It’s going to be different

and I’ve just kind of assumed in this case that We’re using a Finance lease and we haven’t got into the classification I’ve got another CashNews.co on whether it

should even be classified as a Finance lease and this in this example I’m just giving it to you and saying look It’s a bold; color: #1a73e8; text-decoration: none;">Finance lease I’ll make a CashNews.co on How It’s operating lease is different but I want to show you some of the journal entries of how this would all play out so when you initially Capitalize the Truck when you

initially Capitalize the Truck You’re going to have to make a journal entry to reflect the right of use asset You’re going to debit that for 56,68 remember That’s the present value of the lease payments and That’s also the lease liability initially so

We’re going to Credit lease liability 5,668 so That’s just saying We’re going to book An asset We’re going to book a liability In The Beginning right That’s day one but then we make our first payment and we say Ok we debit the least liability you debit

a liability it reduces it we Credit it for Cash of 20,000 We already saw that here in our effective interest table That’s Pretty simple but Now I want to get into this interest expense and the amortization expense Ok so the interest expense We saw that first interest $2200 so

We debit interest expense $2200 and then We Credit leas liability for 22 And you see here It’s December 31 2017 up here I’d said January 1 2018 technically If December 31st was your Year end You would accrue the interest expense Uh on that Year end date Ok and then also

Though You’re going to debit amortization expense for 8,89 and What is that That’s that 5,668 which originally book for right of use asset divided by 3 every year We’re going to reduce that right of use asset by 18,89 and the corresponding debit will be amortization expense so

There’s really two expenses here that would affect Uh net Income and be on the Income statement interest expense of 2200 amortization expense of 1,889 Now we do We just follow the same thing for the when we have the second payment We debit lease liability for

20,000 Credit Cash for 20,000 And Again We have interest expense and we said it was 1,132 and the second time around because the lease liability that was accruing interest was Lower and so that that interest Uh increases the lease liability and then We Again have amortization

expense 8,89 We Credit right a use asset 18,89 That’s the same every year Ok the final payment we debit the least liability for $220,000 and then We Credit Uh the Cash Uh for $220,000 to reflect that okay now we’ve reduced this lease liability we

don’t have any interest expense there’s no interest expense for this Final Year Because we made this payment We made this payment on January 1st of 2019 so At The Beginning of the year So now the least liability is done the least liability has been brought to zero so it can’t

accrue any interest so we don’t have any interest expense Uh this This Final Year but we still do have amortization expense and that Again is 18889 and then We Credit right of use asset for 889 so at the end of When This Is All said and done now We see that the the right of

use asset is got a little typo there the right of use asset is going to be Zero the least liability is going to be Zero and We’re all set we’ve accounted for our lease