Understanding journal entries

How to understand lease accounting journal entries

By

EZLease team
Recording journal entries for lease accounting is critical to accurately reflect the financial picture of a company. Lessees and lessors need to carefully consider the terms of each lease agreement to determine which accounting method, operating or capital, should a lease be classified as. Depending on the classification, different entries are made to the books.

Journal entries for different types of leases

Operating leases are those in which the leased asset is used by the lessee over the life of the lease term and the lessee records lease payments as a balance sheet item and as expenses on the income statement. In contrast, capital leases are those in which the lessee obtains ownership of the asset at the end of the lease term or has the option to purchase the asset at a price significantly below fair market value. The lessor continues to own and depreciate the asset on their balance sheet. Lease payments made by the lessee under a capital lease are split between principal and interest components which reduces the debt recognized against a finance lease on the balance sheet and interest accrued over time on the remaining debt and is recorded in the income statement.

Journal entries for operating leases

For every payment made, a lessee will credit cash and debit the lease expense account. The balance in the lease expense account represents the amount of money a company owes for operating leases in a given period. If the payment has not yet been made by the end of accounting period, a journal entry is made to adjust the accrual of lease payments. This is done by debiting accrued expenses and crediting deferred income or rent payable. Depending on when rent is scheduled to be paid, this could create either a prepaid or unearned revenue asset.

Journal entries for capital leases

For capital leases, entries are more complicated. In order to record a capital lease, both lessees and lessors must make journal entries. Lessees need to book two separate entries: one for the asset and one for the liabilities. The first entry for the lessee is to debit the assets account and credit lease liability for the total amount of the lease. The second entry for the lessee is to debit interest expense and credit lease liability for the amount of interest on the loan. At the end of each accounting period, a company will need to make an accrual adjustment by debiting accrued expenses and crediting lease liability.

Journal entries and lease accounting standards

Lease accounting standards, including ASC 842, IFRS 16 and those governed by the Government Accounting Standards Board (GASB 87/96) carry different requirements for journal entries as well.

 

ASC 842

ASC 842 requires companies to use the modified retrospective method when adopting the new lease standards. This means that lessees will need to record a journal entry for all existing leases as of the date of adoption. The journal entry will include a debit to the right-of-use asset and a credit to the lease liability. The debit to the right-of-use asset is equal to the present value of all remaining lease payments (initial lease liability) PLUS initial direct costs PLUS prepayments LESS any lease incentives. The credit to the lease liability is also equal to the present value of all remaining lease payments.

For both operating and capital leases, lessees will need to make a separate journal entry for each individual lease contract. The total amount of the journal entry will be the sum of all the individual entries.

 

IFRS 16

The journal entries for leases under IFRS 16 are similar to those for ASC 842. The main difference is that IFRS 16 follows a single-model approach when recognizing depreciation of right-of-use asset and interest on a straight-line basis.

 

GASB 87

GASB 87 requires lessees to use implicit rate when calculating the present value of lease payments. However, if the implicit rate is not readily available to the lessee, Incremental Borrowing Rate (IBR) may be used. The journal entry will include a debit to right-of-use asset and a credit to lease liability. The debit to the right-of-use asset is equal to the present value of all remaining lease payments, plus any upfront payments, plus initial direct costs less any lease incentives received. The credit to the lease liability is equal to the present value of all remaining lease payments.

 

GASB 96

Journal entries for GASB 96 are very similar to GASB 87. The main difference is that GASB 96 may have implementation related costs that may be capitalizable.



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