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# 3 Essential Procedures for Lease Accounting [Step-by-Step]

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I’ve discuss about accounting for lease lots, in many forms and cases, the concepts, theories and the standard. In this post I provide 3 essentials step-by-step procedures to proper accounting for lease. They are based on the IAS 17 requirements. Read on…

### 9 Steps Procedure to Determine Accounting for a Finance Lease—Lessee

A typical lease is recorded by the lessee as an operating lease. Under IAS 17, the lessee must record a lease as a finance lease if a substantial number of all the benefits and risks of ownership have been transferred to the lessee. Use this nine-step procedure to determine the correct accounting for a finance lease during all phases of the lease term:

Step-1. Upon receipt of the finance lease documents, collect this information to be used in the determination of lease-related journal entries:

• The lease term
• The amount of annual lease payments
• Any required lease term extensions (i.e., at the option of the lessor, or if a significant penalty will be incurred if the lease is not extended)
• The corporate incremental borrowing rate
• The interest rate implicit in the lease
• The fair value of the asset
• The residual value of the asset at the end of the lease term
• Any guaranteed residual value to be paid back to the lessor
• The dollar amount of any bargain purchase option
Taxes and executory costs

Step-2. Determine the interest rate to be used for a present value calculation. The interest rate used to compute the present value should be the implicit rate in the lease.

Step-3. Calculate the present value of the leased asset. To do so:

• Use a present value table to find the present value multiple for an ordinary annuity of \$1 for the lease term, including any required additional lease periods.
• Multiply the above factor by the annual lease payment (not including any legal or executory costs) due to the lessor.
• Also, if there is a final payment, such as a guaranteed residual value, find the present value multiple for an amount of \$1 due at the end of the lease term, including any required additional lease periods.
• Multiply the above multiple by the ending guaranteed residual value due to the lessor.
• Add together the results of the two present value calculations to arrive at the present value of the leased asset.

Step-4. Assign a value to the asset. Use the lesser of the asset present value, as calculated in the last step, or the fair value of the asset.

Step-5. Record the asset acquisition. Using the value obtained in the last step, record a debit to the appropriate leased asset account and a credit to the Lease Obligation account.

Step-6. Calculate the proportion of each lease payment assigned to interest expense and a reduction in the lease obligation. And here is how:

• Create a table with one row assigned to each year of the lease.
• Number the years in the leftmost column, followed by columns containing the annual payment amount, interest expense, reduction in the lease obligation, and the remaining lease obligation.
• Fill in all rows in the column for annual payments, using the lease payment schedule contained in the lease agreement. Then multiply the predetermined asset value by the predetermined interest rate, resulting in an entry in the Interest Expense column for the first year.
• Subtract this expense from the annual payment, with the remainder dropping into the Reduction in Lease Obligation column. Then subtract the amount just placed in the Reduction in Lease Obligation column from the beginning asset value, and put the remainder in the Remaining Lease Obligation column.
• Continue this process for all years of the lease.

Step-7. Enter the asset in the property, plant, and equipment register, using the predetermined asset value as the acquisition cost. If the asset is to be returned to the lessor at the end of the lease, use the lease term as the asset life for depreciation purposes; otherwise, use the full economic life of the asset. For the purposes of calculating depreciation, reduce the asset value by its expected residual value (not the guaranteed residual value to be paid to the lessor, if any such payment clause exists).

Step-8. Upon termination of the lease:

• Remove the asset from the property, plant, and equipment register and cancel the lease obligation.
• Record a debit to the Accumulated Depreciation account for the full amount of depreciation expense charged against the asset, with the offsetting credit going against the asset account for the amount of the original asset entry.
• Also record a credit for the amount of any guaranteed residual value due back to the lessor.
• Finally, enter a debit to cancel the amount of any remaining lease liability, which should be the difference between the guaranteed residual value and the residual value used initially to reduce the asset value for depreciation calculation purposes.

Step-9. Send notice of the lease cancellation to the legal department and accounts payable staff, so the legal staff can archive the leasing documents and the accounts payable staff can halt any recurring lease payments set up in the accounting system.

### 11 Steps Procedure for Accounting for a Sales-Type Lease—Lessor

If the lessor treats a lease as a sales-type lease, the initial transaction bears some similarity to a standard sale transaction, except that there is an unearned interest component to the entry. Use this 11-step procedure to determine the correct accounting for a sales-type finance lease by the lessor during all phases of the lease term.

Step-1. Upon receipt of the finance lease documents, collect this information to be used in the determination of lease-related journal entries:

• The lease term
• The amount of annual lease payments
• Any required lease term extensions (i.e., at the option of the lessor, or if a significant penalty will be incurred if the lease is not extended)
• The implicit interest rate in the lease
• The carrying value of the asset
• The residual value of the asset at the end of the lease term
• Executory costs

Step-2. Create the initial transaction journal entry for the lease by calculating all components of the entry:

• Determine the amount of the lease receivable by summing all minimum lease payments, minus executory costs, plus the actual residual value of the asset.
• Determine the cost of goods sold by subtracting any initial direct costs from the asset carrying value, minus the present value of the actual residual value. Find the present value by calculating the present value multiplier for \$1 due at the end of the lease term, using the lessor’s implicit interest rate, and multiplying this by the residual asset value.
• Determine the lessor total revenue from the lease transaction by calculating the present value of all minimum lease payments. Find the present value by calculating the present value multiplier for an ordinary annuity of \$1 due at the end of the lease term, using the interest rate implicit in the lease, and multiplying this by the annual lease payments from the lessee.
• Determine the lessor’s inventory reduction by locating the carrying value of the asset being leased to the lessee.
• Determine the unearned interest portion of the lessee’s prospective lease payments by subtracting from the lease receivable the present value of the minimum lease payments and the actual residual value. Find the present value of the minimum lease payments by calculating the present value multiplier for an ordinary annuity of \$1 due at the end of the lease term, using the lessor’s implicit interest rate, and multiplying this by the annual lease payments from the lessee.

Step-3. Once all components of the initial lease entry have been calculated, record the lease receivable and cost of goods sold as debits, and the revenue, inventory, accounts payable, and unearned finance income as a credit.

Step-4. Calculate the proportion of each lessee payment assigned to interest income and a reduction in the lessee’s lease obligation. Here are how:

• Create an effective interest table with one row assigned to each year of the lease.
• Number the years in the leftmost column, followed by columns containing the annual payment amount, interest income, reduction in the lease obligation, and the remaining lease obligation.
• Fill in all rows in the column for annual payments, using the lease payment schedule contained in the lease agreement.
• Then multiply the predetermined asset value by the predetermined interest rate, resulting in an entry in the Interest income column for the first year.
• Subtract this revenue from the annual payment, with the remainder dropping into the Reduction in Lease Obligation column.
• Then subtract the amount just placed in the Reduction in Lease Obligation column from the beginning asset value, and put the remainder in the Remaining Lease Obligation column.
• Continue this process for all years of the lease.

Step-5. Every time the lessor receives a lease payment from the lessee, record a debit to Cash and a credit to the Lease Receivable account for the full amount of the payment. Also enter a debit to the Unearned Interest account and a credit to the Interest Income account for the amount of the interest income component of the lessee payment, as noted in the effective interest table constructed in the last step.

Step-6. At least annually, record any permanent reductions in the estimated residual value of the leased asset.

Step-7. Near the end of the lease period, issue a written notification to the lessee regarding the approaching termination date and explaining lease renewal and asset return options.

Step-8. Upon receipt of written notice from the lessee to not renew the lease, notify the lessee of the address to which the asset is to be shipped, and issue a receiving approval to the receiving staff.

Step-9. The receiving staff inspects the asset for any unusual damage and notifies the accounting department of the cost of any required repairs to the asset.

Step-10. The accounting department bills the lessee for any indicated asset repair costs.

Step-11. Upon termination of the lease and return of the asset to the lessor, record a debit to the Asset account and a credit to the Lease Receivable account for the residual value of the returned asset.

### 12 Steps Accounting for a Direct Financing Lease—Lessor

If the lessor treats a lease as a direct financing lease, it will only recognize interest income from the transaction; there will be no additional profit from the implicit sale of the underlying asset to the lessee. This treatment arises when the lessor purchases an asset specifically to lease it to the lessee. Use this 12-step procedure to determine the correct accounting for a direct financing finance lease by the lessor during all phases of the lease term.

Step-1. Upon receipt of the finance lease documents, collect this information to be used in the determination of lease-related journal entries:

• The lease term
• The amount of annual lease payments
• The implicit interest rate in the lease
• The carrying value of the asset
• The residual value of the asset at the end of the lease term
• The total of all initial direct costs

Step-2. Create the initial transaction journal entry for the lease by calculating all components of the entry, which are:

• Determine the amount of the lease receivable by summing all minimum lease payments, plus the actual residual value of the asset.
• Summarize all initial direct costs associated with the new lease.
• Determine the lessor’s asset reduction by locating the carrying value of the asset being leased to the lessee.
• Determine the unearned interest portion of the lessee’s prospective lease payments by subtracting the asset carrying value from the lease receivable.

Step-3. Once all components of the initial lease entry have been calculated, record the lease receivable and initial direct costs as debits and the asset, unearned finance income, and any cash paid out for the initial direct costs as a credit.

Step-4. Calculate a revised implicit interest rate for the transaction that allows for the amortization of initial direct costs over the lease term. To do so, summarize by year the annual cash inflows and outflows associated with the lease, including the asset purchase price, initial direct costs, annual lease payments from the lessee, and the amount of the residual value. Incorporate this information into the IRR( ) formula in an Excel spreadsheet to determine the lease’s internal rate of return.

Step-5. Calculate the proportion of each lessee payment assigned to interest income, a reduction of the initial direct costs, and a reduction in the lessee’s lease obligation. To do so:

• Create an effective interest table with one row assigned to each year of the lease.
• Number the years in the leftmost column, followed by columns containing the annual payment amount, unearned interest reduction, interest income, reduction of the initial direct costs, reduction in the lease obligation, and separate columns for reductions in the remaining lease obligation where the initial lease obligations both include and exclude the initial direct costs.
• Fill in all rows in the column for annual payments, using the lease payment schedule contained in the lease agreement.

Then follow these steps to complete each row of the table:

• Multiply the original implicit interest rate by the beginning balance in the second Remaining Lease Obligation column (which does not include the initial direct costs), resulting in an entry in the Unearned Interest Reduction column for the first year.
• Multiply the revised implicit interest rate by the beginning balance in the first Remaining Lease Obligation column (which includes the initial direct costs), resulting in an entry in the Interest Income column.
• Subtract the Interest Income from the Unearned Interest Reduction and enter the difference in the Reduction of Initial Direct Costs column.
• Subtract the Interest Income from the Annual Payment and enter the difference in the Reduction in Lease Obligation column.
• Subtract the principal portion of the annual lease payment from the Beginning Lease Obligation column that includes initial direct costs and enter the result in that column.
• Subtract the principal portion of the annual lease payment from the Beginning Lease Obligation column that does not include initial direct costs and enter the result in that column.

Step-6. Every time the lessor receives a lease payment from the lessee, record a debit to Cash and a credit to the Lease Receivable account for the full amount of the payment. Also enter a debit to the Unearned Finance Income account, a credit to the Interest Income account for the amount of the interest income component of the lessee payment, and a credit to the Initial Direct Costs account for the scheduled amortization of that account, as noted in the effective interest table constructed in the last step.

Step-7. At least annually, record any permanent reductions in the estimated residual value of the leased asset.

Step-8. Near the end of the lease period, issue a written notification to the lessee regarding the approaching termination date and explaining lease renewal and asset return options.

Step-9. Upon receipt of written notice from the lessee to not renew the lease, notify the lessee of the address to which the asset is to be shipped, and issue a receiving approval to the receiving staff.

Step-10. The receiving staff inspects the asset for any unusual damage and notifies the accounting department of the cost of any required repairs to the asset.

Step-11. The accounting department bills the lessee for any indicated asset repair costs.

Step-12. Upon termination of the lease and return of the asset to the lessor, record a debit to the Asset account and a credit to the Lease Receivable account for the residual value of the returned asset.

1 Comment

#### 1 Comment

1. Mar 22, 2010 at 8:24 pm

Hi Putra,
Great Article!! Very useful!!
Putra, I have a quick question for you…I am wondering if you know of a good lease accounting software…one of my clients is converting from operating lease accounting to finance lease accounting for a vehicle fleet of approx. 100 cars.