Financial Lease Example / Lease Accounting Example – Transfer of Title to Lessee
Below is a financial lease example with a transfer of title to the lessee.
Financial Lease Example Transaction
On January 2022, Mischelle Corporation leased a piece of machinery from Jaira Corporation for 5 years at an annual rental of Currency Units (CU) 80,000 payable at the end of each year. The estimated life of the machinery is 5 years and the lease provides for a transfer of ownership of the machinery to the lessee at the end of the lease term.
The implicit interest rate for the lease is 10%.
Present Value Computation
The present value of the annual payments of CU 80,000 for 5 years is determined using the 10% implicit interest rate.
Present value = CU 80,000 x present value of an ordinary annuity of 1 for 5 years at 10%
= CU 80,000 x 3.7908
= CU 303,264
The present value factor of 3.7908 is derived from the mathematical table of present value and annuity.
Journal Entry of the Lessee for the Initial Recognition of ROU and Lease Liability
The journal entry to record then the finance lease at the commencement of the lease is as follows:
Dr. Right of use asset 303,264
Cr. Lease liability 303,264
Depreciation of Right of Use Asset
If the lease transfers ownership of the underlying asset to the lessee at the end of the lease, the depreciation of the right-of-use asset is based on the useful life of the underlying asset.
Accordingly, the annual depreciation of the right-of-use asset is recorded as follows:
Dr. Depreciation expense 60,653
Cr. Accumulated depreciation 60,653
Accounting for Fixed Lease Payments
The annual rental of CU 80,000 shall be treated as payment for the principal and interest on the lease.
The interest expense is the difference between the total gross payments for the whole term of the lease (CU 80,000 x 5 = CU 400,000) and the present value of CU 303,264, or CU 96,736.
The total interest amounting to CU 96,736 is recognized as an expense over the total term of the lease following the effective interest method of amortization.
Table of Amortization
Here is the amortization table that we will use to record the annual payments and the related interest expense.
Present value – we have recorded above the recognition of the CU 303,264 right-of-use assets which is the present value of the lease payments as shown in the table below. The present value is the balance of the lease liability after deducting the annual principal payments.
Payment – is the annual lease or fixed payment which is CU 80,000.
Interest – is equal to the foregoing present value multiplied by the implicit interest rate of 10%. Thus, for 2022, the interest is CU 303,264 x 10% = CU 30,326, and for 2023, the interest is CU 253,590 x 10% = 25,359, and so on.
Principal – is the portion of annual rental payments less interest. Thus for 2022, the principal payment nets to CU 49,674 (CU 80,000 – CU 30,326).
Journal Entries For the Interest Expense and Lease Principal Payments
Dec. 31, 2022
Dr. Interest expense 30,326
Dr. Lease liability 49,674
Cr. Cash 80,000
Dec. 31, 2023
Dr. Interest expense 25,359
Dr. Lease liability 54,641
Cr. Cash 80,000
Financial Statement Presentation
The right-of-use assets will be reported as a separate line item under noncurrent assets in the financial statements.
For a December 31, 2022 financial statement, the presentation would be as follows:
Right of use asset 303,264
Accumulated depreciation (60,653)
Carrying amount 242,611
The lease liability would then be reported as partly:
Current – CU 54,641 (2023 principal payment)
Noncurrent – 198,949 (remaining present value after 2023 principal payment)’
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