You’re in need of a office space and let’s presume you have two options – whether to buy a small place or rent another. They are equally suitable both in terms of interior and their place in the neighbourhood. Which one would you go for?
On one hand you could buy a place, which in return would be yours. You’d have full rights deriving from ownership over the place, i.e. refurnishing, remodelling etc. You’d have all the rights to use the place as you see fit and as the neighbours allow obviously. A downside of an ownership is that you’re tied to various obligations to maintain the premises not just clean but also fixed and renovated. Yes, if it’s part of a bigger building, it’s not just you alone, but still. You’d be part of all the other owners who face that obligation. Continue reading
After initial recognition you end up having an asset and a liability on your balance sheet. Now when it comes to subsequent measurement and entries, there are a couple of things relevant to it.
First off is the depreciation. The asset is depreciated the same way as every other asset in the group it was recognized in. Also the useful lives are determined the same as to every other similar asset the company is holding. As a general rule though the useful life should never be longer than the rental period.
The entry every month:
Dr Depreciation expense
Cr Accumulated depreciation
The lease liability is treated as every other long-term liability essentially. Short-term part of it is the amount due in next 12 months and everything else is long-term.
When you have worked out your contract and deemed it is more a finance rather an operating lease, you need consider it as your own asset. “Finance” essentially means that someone else financed the purchase of your asset. As a result, this ‘someone’ is leasing the asset out to you asking for a rental fee. In accounting this is called a finance lease liability as in essence you acquired an asset with third party resources.
As you no doubt can already figure out, the first steps are to recognize both the asset and the corresponding liability on the balance sheet. The very first entry is as follows:
Db PPE (into the group the asset most suits and in the amount yet to be paid for the asset)
Cr Finance lease liability (the amount yet to be paid for the asset)
When operating lease is really straightforward and only comprises of one linear expense on the income statement, finance lease is a bit more complicated than that and also comprises of couple of other financial statement lines being affected.
Before we can however start digging deeper into recognizing the finance lease on the balance sheet, we need to determine when we are even talking about finance lease. There are a couple of situations which usually indicate that the contract should be accounted as a finance lease (although the name of it may be ‘operating lease’). Mind you that if already one of those conditions is met, it is high chance the lease is in essence a finance lease.
You may encounter leases in all sorts of businesses. It can be to lease machinery for production, a car for everyday use or small office supplies like a coffee machine. As such when we talk about leases and leasing, we essentially mean gaining a right to use an asset.
When you lease an asset, you regularly pay a certain amount to the lessor for the right to use the asset. However, in certain types of leases you may also get the obligation to take care of maintenance and all similar costs, so in essence, in addition to the right to use the asset (‘reward’), you also gain the risks. In accounting, the leases where substantial risks and rewards transfer from the lessor to the lessee are called ‘finance leases’. When defining ‘substantial’, we do mean on the scale it is incidental to the ownership itself.
Finance leases are in other words also called capital leases. Shortly of the meaning of finance lease – it’s an arrangement where the borrower chooses an asset, the finance company will purchase the asset and the borrower will use the selected asset during the period of lease. During this very same period the borrower pays to the finance company series of installments for the use of the asset. Usually the borrower will also have an option to acquire the asset, but that’s not relevant at the moment to the interest calculation methods.
Regardless of the fact that in Medieval Ages charging for interest was not well looked upon to say the least, in nowadays interest is something we all agree that makes sense. Moreover, it makes sense in the form that you are giving or you are given the ability to use someone else’s asset (whether its money, car or something else). From such activities interest is considered to be as compensation to the lender as he or she could have done something else with the asset, but instead it was given for you to use. As it is reasonable to believe that assets should always earn income or give value, giving it to someone else for use is just another means of an asset generating income really.