Finance Leases
What is a Finance Lease
A finance lease is a funding structure for an asset in which the lease transfers substantially all the risks and rewards of ownership to the lessee. It usually involves payment to the lessor the full cost of the asset together with a return on the finance provided by the lessor. Finance leases are commonly found in the financing of specific assets for a business, such as a machine for production. If you believe the lease is more in the way of an operating lease please refer to the Operating Lease User Guide. If you are unsure as to what lease type you are considering you are strongly recommended to consult your advisor.
What is the significance of a lease type
The accounting for an operating lease is different from that of a finance lease. For a finance lease, the capital value of the lease is treated as a fixed asset. The liability to pay the lessor is shown as a creditor. The financing (interest) is charged to the Profit and Loss account on a regular basis. It can be complex and you are advised to agree with your accounting advisor the accounting entries.
For operating leases no fixed asset or creditor accounting is required. The rentals under an operating lease should be charged on a straight-line basis over the lease term, even if actual payments are made on a different basis. For example if there is a rental holiday for the first three months (although the asset is in use during these three months) of a five year lease, the total rentals should be charged to profit and loss over the period in which the asset is in use. The system has specific functionality to properly deal with operating leases.
Initiating a Finance Lease
It is usual for same basic preparatory work to be undertaken to understand the elements that will represent the finance lease; the following example is used to demonstrate a process and accounting to be used in the system.
| Item | Details |
|---|---|
| Cost of leased asset | £20,000.00 |
| Lease Term | 5 Years |
| Rental quarterly in advance | £1,200.00 |
| Residual Value | 1500 |
Using these figures it is possible to calculate the interest rate implicit in the lease; the interest rate that amortises these amounts is 2.2% compounded on a quarterly basis. From this the relevant figures for the whole of the lease can be prepared. Please take appropriate advice if this unclear or you are unsure as to how to compute the interest rate, bearing in mind that the specific circumstances of the lease must be understood and taken into account. The amounts owed to the Lessor and the interest charges are as follows.
| Obligation at Start | Rental Paid | Obligation in period | Interest at 2.20% | Obligation at end | |
|---|---|---|---|---|---|
| £ | £ | £ | £ | £ | |
| Quarter 1 | 20,000 | (1,220) | 18,780 | 413 | 19,193 |
| Quarter 2 | 19,193 | (1,220) | 17,973 | 395 | 18,369 |
| Quarter 3 | 18,369 | (1,220) | 17,149 | 377 | 17,526 |
| Quarter 4 | 17,526 | (1,220) | 16,306 | 359 | 16,665 |
| Quarter 1 | 16,665 | (1,220) | 15,445 | 340 | 15,784 |
| Quarter 2 | 15,784 | (1,220) | 14,564 | 320 | 14,885 |
| Quarter 3 | 14,885 | (1,220) | 13,665 | 301 | 13,965 |
| Quarter 4 | 13,965 | (1,220) | 12,745 | 280 | 13,026 |
| Quarter 1 | 13,026 | (1,220) | 11,806 | 260 | 12,066 |
| Quarter 2 | 12,066 | (1,220) | 10,846 | 239 | 11,084 |
| Quarter 3 | 11,084 | (1,220) | 9,864 | 217 | 10,081 |
| Quarter 4 | 10,081 | (1,220) | 8,861 | 195 | 9,056 |
| Quarter 1 | 9,056 | (1,220) | 7,836 | 172 | 8,008 |
| Quarter 2 | 8,008 | (1,220) | 6,788 | 149 | 6,938 |
| Quarter 3 | 6,938 | (1,220) | 5,718 | 126 | 5,844 |
| Quarter 4 | 5,844 | (1,220) | 4,624 | 102 | 4,725 |
| Quarter 1 | 4,725 | (1,220) | 3,505 | 77 | 3,582 |
| Quarter 2 | 3,582 | (1,220) | 2,362 | 52 | 2,414 |
| Quarter 3 | 2,414 | (1,220) | 1,193 | 26 | 1,220 |
| Quarter 4 | 1,220 | (1,220) | 0 | 0 | 0 |
These items will accounted for as liabilities and as interest charged to the profit and loss account in the appropriate period. This is described below.
Equally in this example the lease term of five years is assumed to be the useful life of the asset and there is no residual value so the depreciation (which will calculated automatically by the asset register) is straight line at £4000 per year (£1000 per quarter)
| Asset at Cost | Depreciation Charge | Cumulative Depreciation | Net Book Value | |
|---|---|---|---|---|
| £ | £ | £ | £ | |
| Quarter 1 | 20,000 | (1,000) | (1,000) | 19,000 |
| Quarter 2 | 20,000 | (1,000) | (2,000) | 18,000 |
| Quarter 3 | 20,000 | (1,000) | (3,000) | 17,000 |
| Quarter 4 | 20,000 | (1,000) | (4,000) | 16,000 |
| Quarter 1 | 20,000 | (1,000) | (5,000) | 15,000 |
| Quarter 2 | 20,000 | (1,000) | (6,000) | 14,000 |
| Quarter 3 | 20,000 | (1,000) | (7,000) | 13,000 |
| Quarter 4 | 20,000 | (1,000) | (8,000) | 12,000 |
| Quarter 1 | 20,000 | (1,000) | (9,000) | 11,000 |
| Quarter 2 | 20,000 | (1,000) | (10,000) | 10,000 |
| Quarter 3 | 20,000 | (1,000) | (11,000) | 9,000 |
| Quarter 4 | 20,000 | (1,000) | (12,000) | 8,000 |
| Quarter 1 | 20,000 | (1,000) | (13,000) | 7,000 |
| Quarter 2 | 20,000 | (1,000) | (14,000) | 6,000 |
| Quarter 3 | 20,000 | (1,000) | (15,000) | 5,000 |
| Quarter 4 | 20,000 | (1,000) | (16,000) | 4,000 |
| Quarter 1 | 20,000 | (1,000) | (17,000) | 3,000 |
| Quarter 2 | 20,000 | (1,000) | (18,000) | 2,000 |
| Quarter 3 | 20,000 | (1,000) | (19,000) | 1,000 |
| Quarter 4 | 20,000 | (1,000) | (20,000) | 0 |
Setting up a Finance Lease in summary
- Enter the leased Asset in the Asset Register
- Create the initial Obligation (Liability) to the Lessor
- Set up a Memorised transaction for the periodic payment to the Lessor
- Create a journal template for the interest charge
- Post the interest as scheduled
- Regularly review and reconcile the relevant accounts
Adding the Lease Asset to the Asset Register
In the first instance this is the same process as for a normal an asset More information is available from the Using the Fixed Asset Register guide The asset register is accessed via the Expenses menu.
Expenses - Assets and/or Vehicles - Add Asset
Enter the relevant information and SUBMIT to create the asset in the register and allow automatic posting of the depreciation charge.
Create the initial Obligation to the Lessor
The asset register entry creates a liability in the Asset Additions accounts pending a payment transaction; in the case of a finance lease asset, however, the liability is moved to either an Obligations under Finance Lease or Obligations under Hire Purchase account as appropriate. Use an Asset Journal to do this: -
Control - Add Journal
Note that if the correct obligation account is not visible use the Add from Standard Accounts process under the Accounts menu.
Use a journal to record the initial obligation to the Lessor; you may view this from the ledger.
Accounts - Current Liabilities
Create a memorised Transaction for the periodic payment to the Lessor
Use an appropriate payment method such as Bill, Cheque or Electronic Payment.
Expenses - Payment
When the initial payment has been recorded, return to the transaction and memorise it with the number of payments set to the balance of the lease payment plan, in this case 19.
Expenses - Payments & Transfers - Locate and EDIT the appropriate one - Click the Memorise tab.
Create a journal template for the interest charge and Post Interest
Create the Journal via the Control menu, using the appropriate interest amount from the lease interest schedule calculated in the preparatory work.
Control - Add Journal
Locate the Journal again (from the Lists menu) and memorise it but do not auto schedule it. The template will then be available for the next occasion via the Lists menu.
Lists - Memorised Transactions - Use
And simply edit the amount as appropriate.
Review
It is recommended that a regular review of the balances on the appropriate accounts be undertaken.