Finance Leases: How to Measure Them and Put Them on Your Books

I would be lying if I said I paid close attention to the lease portion of my schooling. So when I joined Netgain, a company that specializes in automating lease accounting, I needed a refresher, fast. 

When I looked around online to learn about finance leases, I couldn’t find a lot of practical information. Instead, I found a lot of unnecessary words. I had to dig through resources just to find out how to simply measure and capitalize a lease.  

My goal here is to save you time by showing you how to classify a lease as a finance lease and providing examples of how to calculate the necessary accounts for the books. 

Finance leases: old friends with new names. 

ASC 842 changed the previous term “Capital Lease” to “Finance Lease”. That’s it. The accounting for them has largely remained the same. The challenging part is to identify whether or not a lease you have is a finance lease. Here are five criteria in the codification (ASC 842-10-25-2) that, if any are met, classify a lease as a finance lease:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. 
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. 
  3. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease. 
  4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payment in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset. 
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of lease term. 

If your lease does not meet the criteria above, your lease will need to be classified as an operating lease. While both lease types give the lessee the right to use the underlying asset, finance leases entitle the lessee to the risks and rewards associated with the ownership of the asset.

How to get finance leases on the books. 

Finance leases are measured by putting a right-of-use (ROU) asset and a lease liability on the balance sheet. The lease liability is the present value of the lease payments, and the ROU asset equals the lease liability, with a few caveats. The ROU asset balance is increased by prepaid rent and initial direct costs and decreased by lease incentives. Here are some examples.  

Example 1 – Forklift Finance Lease 

Commencement Date—1/1/2020 

Lease Term—36 months 

Initial Lease Payment—$5,000 

Incremental Borrowing Rate—4% 

Payment Timing—In Advance 

=PV(0.04/12,36,-5000,0,) 

= $169,918.34 

(Present Value Formula from Excel) 

In the example above, the ROU asset balance and the lease liability balance would both be equal to $169,918.34. The journal entry to put this lease on your books would be a debit to ROU asset and a credit to lease liability.

ROU Asset Forklift 

$169,918.34 

 

Lease Liability Forklift 

 

$169,918.34 

 

Example 2 

Commencement Date—1/1/2020 

Lease Term—36 months 

Initial Lease Payment—$5,000 

Incremental Borrowing Rate—4% 

Prepaid Lease Payment—$15,000 

Lease Incentives—$3,000 

Payment Timing—In Advance 

=PV(0.04/12,36,-5000,0,) 

 

$169,918.34 

+ 15,000.00 

- 3,000.00 

= $181,918.34 

 

The second example adds a $15,000 lease prepayment and $3,000 of lease incentives. This affects the ROU asset only, increasing the balance by $12,000. The journal entry to record this lease would be as follows: 

ROU Asset Forklift 

$181,918.34 

 

Lease Liability Forklift 

 

$169,918.34 

Cash or Payable 

 

$12,000.00 

 

Bottom line

Finance leases are the new capital leases. Keep that in mind when you’re classifying leases, and follow the five criteria outlined above. When it comes to proper accounting, follow the steps above or invest in a software solution like NetLease for automated classification and accounting. 

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