ACCOUNTING FOR LEASES
• A lease is a binding contract where one party takes possession and use of an asset from the owner in
exchange of regular payments for a specific period of time.
Categories of leases
Operating lease
• An agreement that allows for use and possessions BUT NOT OWNERSHIP of an asset, payments are
reported in the income statement and not balance sheet (off balance sheet financing)
Characteristics of operating leases
• Do not contain a bargain option
• Lease period is less than 75% of asset estimated economic life
• Present Value of lease payments is less than 90% of asset fair market value
• Lease payments are treated as rental expense which are operating expenses
• Depreciation expense is accounted for in books of lessor but not books of lessee
• Since Lessee only has right to use and not own, risk remains with the lessor and lessee is required to pay
maintenance cost which are also operating expenses
Capital/ Finance lease
Capital lease contracts allow for use, possession and ownership of assets from the owner. In the Balance
sheet they are considered as liabilities in the books of the lessee and depreciate over time therefore incur
interest expense.
Characteristics of capital leases
• There is a bargain purchase option to buy the asset below market value
• Lease period is greater than or equal to 75% of assets estimated useful life
• Present Value of lease payments is greater than or equal to 90% of fair value of asset
• Lease payments are not treated as rental expense rather as a source of finance meaning in the balance
sheet a financier/creditor (Landlord A/C) is created and every payment reduces this landlord account.
• Depreciation is accounted for in books of lessee based on useful life AND NOT lease period
• Lessee bears risk in respect of asset residual value
Methods of Lease Payment
Lease payments are either made in arrears or in advance
Advance Payments: Payments are made at the beginning of the payment period which asset is used
Payment in Arrears: Payment is made at the end of the payment period which asset is used
NB: In the case of advance payments there is no interest on finance lease in the first lease payment as the
lessee is yet to use the asset therefore payment made is wholly used to reduce landlord account
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Terms used
• Lessor/Landlord: Original owner of an Asset
• Lessee: Party hiring the asset from the owner
• Primary Lease Period: Period over which Lease payments are payable
• Secondary Lease Period: Period after expiry of primary lease period where tenant has a right to
continue with lease agreement at rental payments lower than those of the market
• Lease Payments: Periodic payments made by lessee to lessor in regards to the lease
Every lease payment is a combination of a periodic amount that reduces the Landlord Account as
well as the period interest expense
• Minimum lease Payment: Total lease payments payable over entire lease period calculated by
multiplying lease period with annual lease payments
• Asset Fair value: Cost of the asset
• Interest on Finance Lease: Total interest income (profit) received by lessor from lessee from the lease
contract calculated by subtracting minimum lease payments from fair value of asset. It is an interest
income to the lessor and an interest expense to the lessee.
Illustration
Determine the total interest on finance lease from the following information and estimate how much interest
expense is paid by the lessee on an annual basis
Asset Value Kshs 400,000
Lease Period 6 years
Lease Payments Kshs 75,000
NOTE
• Interest on Finance Lease is an income to the lessor and an expense to the lessee
• Risk and Depreciation are accounted for in the books of the lessee
• Entries are made in the books of the lessee
Methods of spreading out interest on finance lease
Interest on finance lease can be spread throughout the entire lease period using the following methods:
• Straight line method: It reports interest income per annum calculated by dividing the total interest
on finance lease with the number of years
• Sum of Digits method: Calculated by multiplying the interest on finance lease with the sum of digit
ratio [n(n+1)]/2
• Actuarial Method: Amortization schedule is used where the interest of finance lease for a period is
obtained by multiplying the effective interest with the previous period value of the asset.
Accounting for leases (in books of lessee/Tenant)
Operating Lease
DR: Rent Expense
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CR: Cash/Bank
Finance Lease
Date of Lease Agreement
DR: Asset A/C
CR: Lessor/Landlord A/C
Lease Payments made in arrears
DR: Landlord/Lessor A/C
DR: Interest Expense
DR: Depreciation Expense
CR: Cash/ Bank
CR: Accumulated Depreciation
First Lease Payment made in advance
DR: Landlord/Lessor A/C
CR: Cash/ Bank
Subsequent Lease Payments made in advance
DR: Landlord/Lessor A/C
DR: Interest Expense
DR: Depreciation Expense
CR: Cash/ Bank
CR: Accumulated Depreciation
Actuarial method
• The interest on finance lease for every period is calculated by multiplying the effective interest which is also
the discounting rate with the fair value of assets for every period.
• The face value of an asset is calculated by summing the total of all discounted lease payments of each period.