Watch our video on how lessees should account for finance leases
The effective date of the new leases standard for public companies is rapidly approaching. The new standard is expected to have a significant impact on lessees given the requirement that almost all leases will be on the lessee’s balance sheet going forward. This video covers the basic mechanics on how a lessee should account for a finance lease. This overview includes how to compile the initial and subsequent journal entries and the related calculations supporting such entries. For information on how to account for an operating lease, see the companion lessee operating lease video
Hello! I’m Jordan Adelson, a senior manager in PwC's national office. As a part of our leasing video series, I'm going to discuss how lessees would record the day two accounting for a finance lease. For a description of how a lessee would calculate;
- the amount of the lease liability and the right of use asset for both operating and finance leases; and
- the day two accounting for operating leases,
For context, day 1 accounting refers to the initial recording of the lease at commencement, while day 2 refers to the accounting for the lease after it is initially recorded.
Let's begin with an example. Assume the following terms of the lease:
- The lease has a term of 5 years with annual payments of 1.1 million dollars;
- The first lease payment is due at the lease commencement date, with subsequent lease payments due at the end of each year, starting with year one;
- A lease incentive of 100,000 dollars was provided by the lessor;
- The first lease payment will be reduced by the lease incentive, resulting in a net amount of one million dollars due at lease commencement;
- The lessee has determined its incremental borrowing rate (or IBR) to be 5%;
- The lease liability was 3.9 million dollars and the right of use asset was 4.9 million dollars at the lease commencement date; and
- There are no initial direct costs.
For illustrative purposes we have assumed that the company accounts for the lease on an annual basis.
As a reminder, the accounting for a finance lease is similar to that of an amortizing loan. As a result, a company will record interest expense and amortization of principal over the term of the lease. Interest expense will be calculated using the effective interest method, so at the end of year one, the lessee would debit interest expense for 195,000 dollars, which is the 3.9 million dollar beginning lease liability multiplied by the 5% incremental borrowing rate. The 905,000 dollars of amortization of lease liability is calculated by subtracting the interest expense of 195,000 dollars from the 1.1 million dollars in cash paid at the end of year 1.
Now, let's talk about the asset. Amortization of the right-of-use asset is typically measured on a straight line basis over the lease term. So at the end of year one, the lessee would debit amortization expense and credit accumulated amortization for 980,000 dollars. This is equivalent to the 4.9 million dollar right-of-use asset divided by 5, the lease term.
As a result, the total expense for year one would be 1,175,000 dollars, which is made up of:
- 195,000 dollars of interest expense plus
- 980,000 dollars of amortization expense of the right-of-use asset.
This process would repeat itself over the term of the lease until the lease liability and the right of use asset were reduced to zero by the lease expiration.
As an aside, it is interesting to note that the total expense under the finance lease of 1,175,000 dollars is higher than the 1,080,000 dollars recognized in the first year of the operating lease assuming the same fact pattern. Although total expense over the entire lease term will be the same for both finance and operating leases, the use of the effective interest method to record expense on a finance lease results in a front-loaded expense recognition pattern as compared to expense calculated under the straight-line method for an operating lease.
Now let’s put the pieces together and see the day 2 annual journal entry…
So let's wrap up. With the effective date of the new leases standard quickly approaching, companies have a lot of work ahead of them getting ready for the new standard. But the good news is there are many resources available to help. For more information, please refer to the Leases page
. Thank you.