Accounting Entries of Finance and Operating Lease

What is Finance and Operating Lease?

A finance lease is a lease where the risk and rewards of ownership are transferred to the lessee. In a Finance Lease the lessor allows a lessee to use a particular assets without transfer of title of the goods, but the risks and rewards of ownership are transferred.

Operating lease is the risk where risk and rewards of ownership remain to the lessor. The lessee is permitted by the lessor to use the assets for a limited time which is smaller than the economic life of the assets and the title, risk and rewards of ownership will remain to the lessor.

In a lease, substance over form should be applied to determine whether risks and rewards of ownership transferred. Transfer of legal ownership is not relevant to decide whether a lease is an operating lease or a finance lease.

When an asset is leased under a finance lease there is a difference between the legal form of that traction and its commercial substance. In this respect, the legal owner is the lessor through the lessee making the lease payments and use the assets most or all of its useful life. The lessee has effectively purchased the assets by taking out a loan i.e. Lease liability paid with interest.

Accounting Treatment of Finance Lease

As commercial substance of finance lease is lie with the lessee due to transfer of risk and rewards of ownership, the required accounting treatment will be:

  • record the assets as a non – current asset in the lessee’s statement (Present value of lease payments, or Fair value whichever is lower)
  •  record the liability for the lease payments (Lease liability and Interest)  payable to the lessor

Summary of Accounting Entries:

In the books of Lessor

A) At the start of Lease:

Lease Receivable A/cDebit
Assets A/cCredit

B) At the of time installment receive:

Cash A/cDebit
Lease Receivable A/cCredit
Finance Income A/cCredit

In the books of Lessee

A) At the start of the lease:

Non-Current Assets A/cDebit
Finance Lease Liability A/cCredit

B) At the end of accounting period:

Depreciation Expenses A/cDebit
Non-Current Assets A/cCredit

C) At the time of rental paid:

Lease Liability A/cDebit
Finance Cost (Interest Expenses A/c)Debit
Cash A/cCredit

* Finance cost (interest expenses) will be treated in profit and loss account.

Accounting Treatment of Operating Lease

In the books of lessor

Cash A/cDebit
Lease Rental Income A/cCredit

In the books of lessee

Lease Rental/Expenses A/cDebit
Cash A/cCredit

Conclusion

Now a days lease is a very popular financing tools due to its long term installment facility. By using lease facility a company can enjoy depreciation and interest is the deductible expenses which are tax deductible in nature. The lease rentals of operating lease are also tax deductible expenses.