Finance Lease: Definition, Journal Entry, Accounting Treatment, vs Operating Lease, Example

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A lease is a contractual agreement between two parties. The lessor is the party that grants the use of an asset or property to another party, also known as the lessee. Usually, the lease agreement also includes other terms, for example, the duration, payment schedule, ownership, etc. In accounting, leases may fall into two categories, finance, and operating.

In the past, accounting standards required a series of checks to classify leases. After changes in those standards, most lease agreements fall under a finance lease. Therefore, it is crucial to understand what it is.

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What is a Finance Lease?

A finance lease is a type of lease agreement where the lessee assumes ownership of the underlying asset. Traditionally, this lease included contracts where the lessee reaps most of the rewards associated with that asset. Similarly, if they bear the risks associated with the leased asset, it constitutes a finance lease. However, new accounting standards do not have these requirements.

In the newer standards, most lease agreements that last longer than 12 months fall under finance leases. Therefore, the accounting definition of a finance lease under the new standard includes long-term lease agreements. Companies use this type of lease for machinery, plant, vehicles, and real estate. It is a type of finance that companies utilize to obtain long-term assets.

What is the accounting for Finance Lease?

The accounting treatment for a finance lease requires the lessee to assume they have purchased the asset and taken on debt to pay for it. This accounting treatment goes with the essence of this lease agreement, which is primarily a type of financing. Nonetheless, this accounting treatment is complex and may require several calculations, including amortization.

For finance leases, companies must recognize the leased asset based on the present value of minimum lease payments. The amount after discounting those payments over the lease term constitutes the value of the asset obtained. It is also the amount for which the company must create a lease liability. Companies must further divide this liability into current and non-current portions.

Over time, companies must continue recognizing payments against the lease liability as per the repayment schedule. These payments get divided into their individual principal and interest portions. Usually, this process occurs at the end of each accounting period. Simultaneously, the company must keep depreciating the asset under the applicable accounting standards.

What is the journal entry for Finance Lease?

The first step in the accounting treatment for a finance lease is the journal entry at its initial recognition. As stated above, the amount for this entry comes by discounting the minimum lease payments over the lease term. Once calculated, the journal entry at initial recognition is as below.

Dr Asset
Cr Finance lease

Over time, the company must keep amortizing the finance lease. As stated above, it involves dividing the payment into its interest and principal portions. Consequently, the journal entry would be as follows.

Dr Finance lease (principal portion)
Dr Interest expense
Cr Bank or Cash

This process will also include depreciating the asset at the end of each period. The journal entry to record depreciation is as follows.

Dr Depreciation
Cr Accumulated depreciation

Conclusion

A finance lease is a type of lease agreement companies use to acquire assets. Essentially, it is a financing method for long-term assets. It differs from operating leases which are usually short-term. The accounting for finance leases involves various stages. This treatment results in an asset and a liability recognized in the balance sheet.

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