According to Slide-Lease-Chapter: 03

According to Book-Lease-Chapter: ×

Finance Lease: Example

PMA, Inc is a rail company which has leased out diesel generators from GP, Ltd. To
provide backup to the transportation system during power outages. The lease has
5-year term in which PMA has to make $500,000 payment to GP at the end of each
year. Journalize the inception of the lease and the first payment made by PMA in
the books of the PMA and GP if PV of minimum lease payments is $1,996,355 and
rate of interest implicit in the lease is 8%.
Journalize the transactions in the books of the lessor and lessee if it meets the
recognition criteria of a finance lease.

Accounting for Lessor

The lessor shall record the start of a lease by creating a lease receivable at its net
investment in lease, which is equal to the minimum lease payments discounted at
the rate of interest implicit in the lease.

Journal entry posted at the start of the lease contract:

Debit Credit
Lease Receivable $1,996,355
Asset $1,996,355

At the time of first payment, lessor shall record receipt of cash, reduction in lease
receivable and recognition of finance income:

Debit Credit
Cash $500,000
Lease Receivable ($500,000 − $40,000) $460,000
Finance Income ($500,000 × 8%) $40,000

The reduction in lease receivable reduces the principal balance in lease receivable
to $1,536,355, which shall reduce the next year finance income.

FIN-3201 (INVESTMENT BANKING & LEASE FINANCING) 1

According to Slide-Lease-Chapter: 03
According to Book-Lease-Chapter: ×

Accounting for Lessee

A finance lease in recognition of both an asset and a liability in the books of the
lessee at the inception of the lease at amount equal to present value of minimum
lease payments.

Debit Credit
Leased Asset $1,996,355
Lease Liability $1,996,355

It is quite possible that the lease asset and lease liability are recorded at the
different amounts in the books of lessor and lessee.
At the time of first annual payment, the lease records the following journal entry:

Debit Credit
Lease Liability $460,000
Interest Expense ($500,000 × 8%) $40,000
Cash $500,000

At the end of first year, the lessee shall post one additional entry to recognize the
depreciation expense on the leased asset. It depreciates the leased asset as if it is
an owned asset.

FIN-3201 (INVESTMENT BANKING & LEASE FINANCING) 2

According to Slide-Lease-Chapter: 03
According to Book-Lease-Chapter: ×

Operating Lease: Example

Accounting for operating leases is pretty straightforward because they do not

involve recognition of any asset or liability. The lease income is recognized on a
basis reflecting the use of the asset.
Refer to the example above for finance lease. Journalize the transactions in the
books of lessor and lessee if the lease meets the criteria for recognition as an
operating lease instead of a finance.

Accounting for Lessor

No journal entry shall be made the start of the lease contract.

During the first year, the lessor shall recognize receipt of lease rental as follows:

Debit Credit
Cash $500,000
Lease Rental Income $500,000

Accounting for Lessee

No journal entry shall be made the start of the lease.

At the time of first payment, the following journal entry is required:

Debit Credit
Lease Expense $500,000
Cash $500,000

FIN-3201 (INVESTMENT BANKING & LEASE FINANCING) 3