Accounting for a Finance Lease

Accounting for a Finance Lease

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Hi, can someone provide me with some guidance on accounting for this Finance Lease query?  I have two questions.

Question 1

We acquire an asset on a Finance Lease.  We know the true capital cost of the asset from the actual supplier and so know the cost of finance based on the total commitment to the Finance House.

Therefore I believe the starting accounting entries to be:

1(a). Fixed Asset addition at purchase cost (this is excluding the cost of finance)

1(b). Finance Lease Liability at purchase cost (this is excluding the cost of finance)

Then each month as the payments are made to the Finance House:

2(a). Depreciation charge on asset based on depreciation policy.

2(b). Reduction in Finance Lease liability based on capital element only of monthly payment to finance house.

2(c). Interest charge through the P&L for interest element of payment made to Finance House.

Is this the correct method of accounting for this Finance Lease?

Question 2

The intention will be to take up the option to purchase this asset at the end of the minimum term of the lease.  In order to complete that process the Finance House require a further payment equivalent to 3 months of the regular rental payment.

How do we account for this?  Should this impact the original Fixed Asset addition value?  Because there is no commitment to purchase this asset when the Finance Lease first commences I don't think we should include this at the start of the agreement?

Could someone provide me with a little guidance on this please?

Replies (11)

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By johngroganjga
26th Aug 2016 11:21

Question 1

Yes - although you don't mention how you split the repayments between interest and capital.

Question 2

The balloon payment is just part of your calculation of the interest rate implicit in the lease, which in turn will be your basis for splitting the repayments between interest and capital.

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Replying to johngroganjga:
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By sfirmin
26th Aug 2016 12:03

Thank you for your response. The simplest would be an equal share of the total of each split across the total number of months in the agreement, but I know technically the interest element will be larger at the beginning of the agreement and reducing as the agreement progresses. Are we able to account for it either way?

If we're not contractually committed to the balloon payment, and it only becomes an option at the end of the lease when we terminate it, can we include it in accounting for interest throughout the minimum contractual period?

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Replying to sfirmin:
By johngroganjga
26th Aug 2016 12:25

I would be reluctant to use the straight line method unless the numbers were immaterial. With Excel it takes no time at all to do it all properly.

Yes I think you include the balloon payment in your calculations from Day 1.

All this assumes that it is a finance lease of course.

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By Ruddles
26th Aug 2016 11:37

Are you sure this is a finance lease? A finance lease agreement should not contain any option to purchase the asset at the end of the lease. Finance lease assets are in practice commonly purchased/retained at the end of the lease (and there is often an informal agrement at the outset that this option will be available), but strictly this should be (and normally is) dealt with by way of a separate agreement.

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Replying to Ruddles:
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By sfirmin
26th Aug 2016 12:08

It is definitely a Finance Lease. The agreement doesn't contain any option to purchase at the end. We have been advised that upon termination of the agreement at the end of the minimum period as long as we have complied with all of the T&Cs of the lease agreement one option available to us will be to pay a one off fee equivalent to three further months rental, this will be invoiced as an infinite rental and it will transfer all rights of ownership to our company. Does that fall in line with what you were thinking?

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Replying to sfirmin:
By Ruddles
26th Aug 2016 12:21

Yes - the key words being "The agreement doesn't contain any option to purchase at the end"

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Replying to Ruddles:
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By sfirmin
26th Aug 2016 13:04

Thanks.

Do you agree with johngroganjga on including the "balloon" payment with the interest calculations right from the start of the agreement?

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Replying to sfirmin:
By Ruddles
26th Aug 2016 14:15

No, I don't agree with John. It's not a balloon payment, it's a payment - under a seprate agreement - to effectively take ownership of the asset. So I wouldn't do anything with it until it has actually been incurred - who knows, the trader may decide that at the end of the lease the asset is worthless and choose not to take up the 'option' and simply hand the asset back.

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By mrme89
26th Aug 2016 12:55

Revealing post.

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Replying to mrme89:
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By sfirmin
26th Aug 2016 13:04

In what way?

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Replying to sfirmin:
By mrme89
26th Aug 2016 13:11

sfirmin wrote:

In what way?

In that my post revealed post number 6. There is a problem with the website, but the developers are nowhere to be found.

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