Financial Lease Example / Accounting for Initial Direct Costs in Leases
Below is a sample transaction so we can understand the accounting for initial direct costs in leases.
Transaction Details
On January 1, 2022, Rossel Company leased a machine from Shary Company for 10 years with the details as follows:
| Lease payments every December 31 | CU2,000,000 | |
| Initial direct cost paid | 500,000 | |
| Lease incentives received | 300,000 | |
| Useful life of the machine | 12 years | |
| Incremental borrowing rate | 14% | |
| Implicit interest rate | 12% | |
| Present value of an ordinary annuity of 1 for 10 periods | ||
| 12% | 5.6502 | |
| 14% | 5.2161 | |
| Present value of 1 for 10 periods | ||
| 12% | 0.3220 | |
| 14% | 0.2697 | |
The mathematical table for the present value of 1 and an ordinary annuity can be obtained here – https://accountingupgrade.com/mathematical-tables/.
The guaranteed residual value of the machine at the end of the lease is CU 1,000,000.
Cost of Right of Use Asset
| Present value of lease payments (2,000,000 x 5.6502) | 11,300,400 |
| Present value of guaranteed residual value (1,000,000 x 0.3220) | 322,000 |
| Subtotal | 11,622,400 |
| Initial direct costs | 500,000 |
| Lease incentives received | (300,000) |
| Cost of right of use asset | 11,822,400 |
The present value factor for 12% was used in computing the present value of the lease payments since it is the implicit interest rate. However, if the implicit interest rate cannot be readily determined, the lessee can use the incremental borrowing rate.
Meanwhile, the initial direct costs paid by the lessee and lease incentives received by them are included in the measurement of the cost of right of use asset. This is however excluded in the measurement of the lease liability.
The initial direct costs are added while the lease incentive received by the lessee is deducted in computing the cost of the right-of-use asset.
| Initial direct costs | 500,000 |
| Lease incentives received | (300,000) |
| Net cash payment at the beg. of the lease | 200,000 |
Table of Amortization for Lease Liability
| Date | Payment | Interest | Principal | Present Value |
| Jan. 1, 2022 | 11,622,400 | |||
| Dec. 31, 2022 | 2,000,000 | 1,394,688 | 605,312 | 11,017,088 |
| Dec. 31, 2023 | 2,000,000 | 1,322,051 | 677,949 | 10,339,139 |
| Dec. 31, 2024 | 2,000,000 | 1,240,697 | 759,303 | 9,579,835 |
| Dec. 31, 2025 | 2,000,000 | 1,149,580 | 850,420 | 8,729,415 |
| Dec. 31, 2026 | 2,000,000 | 1,047,530 | 952,470 | 7,776,945 |
| Dec. 31, 2027 | 2,000,000 | 933,233 | 1,066,767 | 6,710,179 |
| Dec. 31, 2028 | 2,000,000 | 805,221 | 1,194,779 | 5,515,400 |
| Dec. 31, 2029 | 2,000,000 | 661,848 | 1,338,152 | 4,177,248 |
| Dec. 31, 2030 | 2,000,000 | 501,270 | 1,498,730 | 2,678,518 |
| Dec. 31, 2031 | 2,000,000 | 321,482 | 1,678,518 | 1,000,000 |
Journal Entries – Accounting for Initial Direct Costs
2022
1. To record the right-of-use asset and the lease liability.
| Dr. Right of use asset | 11,822,400 | |
| Cr. Lease liability | 11,622,400 | |
| Cr. Cash (500,000-300,000) | 200,000 |
2. To record the first payment of December 31, 2022.
| Dr. Interest expense | 1,394,688 | |
| Dr. Lease liability | 605,312 | |
| Cr. Cash | 2,000,000 |
3. To record the depreciation for 2022.
| Dr. Depreciation | 1,082,240 | |
| Cr. Accumulated depreciation | 1,082,240 |
| Cost of right-of-use asset | 11,822,400 |
| Residual value guarantee | (1,000,000) |
| Depreciable amount | 10,822,400 |
| Lease term (in years) | 10 |
| Yearly depreciation | 1,082,240 |
The residual value guarantee will be subtracted from the cost of right of use asset to arrive at the depreciable amount of CU 10,822,400.
Meanwhile, the number of years used to depreciate the underlying asset is 10 years since there is a residual value guarantee.
2023
1. To record the second payment of December 31, 2022.
| Dr. Interest expense | 1,322,051 | |
| Dr. Lease liability | 677,949 | |
| Cr. Cash | 2,000,000 |
2. To record the depreciation for 2022.
| Dr. Depreciation | 1,082,240 | |
| Cr. Accumulated depreciation | 1,082,240 |
Depreciation Table for Cost of Right of Use Assets
| Year | Depreciation | Accumulated | ROU asset |
| Start | 11,822,400 | ||
| 2022 | 1,082,240 | 1,082,240 | 10,740,160 |
| 2023 | 1,082,240 | 2,164,480 | 9,657,920 |
| 2024 | 1,082,240 | 3,246,720 | 8,575,680 |
| 2025 | 1,082,240 | 4,328,960 | 7,493,440 |
| 2026 | 1,082,240 | 5,411,200 | 6,411,200 |
| 2027 | 1,082,240 | 6,493,440 | 5,328,960 |
| 2028 | 1,082,240 | 7,575,680 | 4,246,720 |
| 2029 | 1,082,240 | 8,657,920 | 3,164,480 |
| 2030 | 1,082,240 | 9,740,160 | 2,082,240 |
| 2031 | 1,082,240 | 10,822,400 | 1,000,000 |
Return of the Machine to the Lessor at the End of the Lease
On December 31, 2031, the lessee will return the machine to the lessor. Here then are the entries of the lessee to return the underlying asset to the lessor.
| Dr. Accumulated depreciation | 10,822,400 | |
| Dr. Lease liability | 1,000,000 | |
| Cr. Right of use asset | 11,822,400 | |
Next Lesson – Practical Illustration – Lease With Unguaranteed Residual Value and Required Restoration Cost