Finance lease is a type of long-term financing where the company enters the lease agreement to use the property or asset for a long period of time. In the journal entry of finance lease, the company needs to record the present value of total lease payments on the balance sheet.
Unlike an operating lease, a finance lease is more like a purchase on installment than a rental. Likewise, the company needs to initially record the fair value of lease payments as a lease asset on one side and a lease liability on the other side.
Subsequently, the journal entry will also involve the deprecation of the lease asset as well the interest expense on the lease liability. That is why the finance lease is considered much more complicated than the operating lease.
The company can make the finance lease journal entry by debiting the lease asset account and crediting the lease liability account.
In this journal entry, the amount of lease asset or lease liability recorded is the fair value of total lease payments. In other words, it is the present value of whole lease payments in the lease contract.
The lease asset is presented on the balance sheet, which is similar to the fixed asset. Likewise, the lease asset will need to be depreciated over the useful life of the lease period. Hence, the company needs to record depreciation expense in each period with the straight-line depreciation method.
The lease liability is presented on the balance sheet, which is similar to the loan. In this case, each payment that the company makes for the lease is similar to a mortgage payment which consists partly of interest expense and partly of repayment of debt. Likewise, the company can make the journal entry for the finance lease payment as below:
For example, the company ABC Ltd. enters a long-term lease agreement which is a finance lease for the use of equipment. The lease period is 5 years which is approximately the economic life of the leased equipment.
The lease calls for the annual payment of $10,000 each year for the 5 years period and the market interest rate is 8% per annum.
Solution:
Initial recognition
The present value of the total lease payments can be calculated as in the table below:
In this case, ABC Ltd. can make the finance lease journal entry with the debit of lease asset and the credit of lease liability as below:
Finance lease deprecation
The finance lease deprecation in each year of the lease period can be calculated using the straight-line depreciation method with no salvage value as below:
Annual depreciation = 39,927 / 5 = 7,985
Hence, the company can make the journal entry for the finance lease depreciation at the end of each year as below:
After this journal entry, the net book value of lease asset is $31,942 (39,927 – 7,985).
Finance lease payment
As the lease term is 5 years and the interest rate is 8% per annum, the schedule of lease payments can be presented as in the table below:
So, the company ABC Ltd. can make the journal entry for the lease payment in the first year with the interest expense of $3,194 and the lease liability reduction of $6,806 as below:
After this journal entry, the balance of lease liability is $33,121 (39,927 – 6,806). Likewise, at the end of the lease period, both the net book value of the lease asset and the balance of lease liability will become zero.
It is useful to note that the portion of the lease liability that is expected to be paid in the next year should be presented as a current liability in the balance sheet while the remaining portion is represented as a non-current liability.