Example – Capital Lease Accounting Under this arrangement, the lessor recognizes the gross investment in the lease and the related amount of unearned income.The gross investment in the lease is calculated as: On 1 January 20X1 Entity A (a lessor) enters into a 5 year equipment lease contract with Entity X (a lessee). Financial reporting standards expert Steve Collings works through an example of a finance lease and how the interest is recognised under FRS 102 using the effective interest method. And the asset will mostly stand in the balance sheet either fully depreciated or with a nominal depreciated value. Key IAS 17 Leases Definition. Under FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland , leasing transactions are dealt with in Section 20 Leases . A capital lease, referred to as a finance lease under ASC 842 and IFRS 16, is a lease that has the characteristics of an owned asset. As a result, a company will record interest expense and amortization of principal over the term of the lease. Assume the following: Company A leases machinery from Company B on Jan. 1, Year 1; The lease period is for 15 years Assume the following terms of the lease: ... As a reminder, the accounting for a finance lease is similar to that of an amortizing loan. In a finance lease, the lessor derecognizes the underlying asset and recognizes a receivable equal to the net investment in lease. In accounting, for a capital lease, the lessee records the leased asset as if he or she purchased the leased asset using funding provided by the lessor. A direct financing lease is a financing arrangement in which the lessor acquires assets and leases them to its customers, with the intent of generating revenue from the resulting interest payments. In summary, the accounting topic of leases is a really important accounting area and is highly examinable. Nonetheless, financial statement preparers for organizations in complicated leasing arrangements may have difficulty applying these provisions. Example: Accounting for a finance lease by a lessor. The following information is relevant for this lease: annual lease payments of $20,000 are made at the end of each year Examples of Accounting for Finance Leases by a Lessee. The accounting for capital lease is done considering the property to be owned by the lessee and recording such property as a fixed asset in the books of accounts of the lessee, charging depreciation on the same and the lease payments are charged to P&L after dividing the amount as principal and interest. A finance lease is a lease which transfers substantially all the risks and rewards inherent in the leased asset to the lessee under the lease arrangement. To master this topic, ensure that you know the definitions of both types of lease, the recognition criteria for a finance lease and practise plenty of examples of accounting for finance leases. Now let’s understand these steps and accounting entries with an example. Let's begin with an example. Lessor accounting for a finance lease under GASB 87. Capital Lease Accounting Example Suppose a business enters into a capital lease agreement for an asset worth 12,000 and agrees to pay a deposit of 1,500, leaving a balance of 10,500 to be financed by a capital lease with an implicit annual interest rate of 7% requiring a further four annual rental payments of 3,100. Inception date of lease: The earlier of lease agreement and the date of commitment by the parties.The type of lease is identified at the date of inception. Interest rate implicit in lease: That makes present value of lease payment and UN-guaranteed value equal to fair value and ( any ) initial direct costs of lessor. In this example, the lessee leases a piece of machinery, and the lease is classified as a finance lease. Moreover, the lease liability account will become zero at the end of the lease term. The example below provides journal entries for a lessor’s accounting for a lease arrangement under GASB 87 on the effective date of the agreement, the first month, and subsequent months.