Accounting for Lease Purchase Agreement: Understanding the Basics
Lease purchase agreements are an increasingly popular way for businesses to acquire equipment and machinery without having to pay the full price upfront. They involve a contract between the lessee (the company) and the lessor (the equipment provider), which essentially allows the former to lease the equipment for a fixed period before deciding whether to purchase it outright at the end of the lease term.
While lease purchase agreements can be beneficial for businesses looking to manage their cash flow, they can also present accounting complexities that need to be considered. In this article, we will explore the basics of accounting for lease purchase agreements, and what businesses need to keep in mind when evaluating these agreements.
1. Identify the type of lease
The first step in accounting for lease purchase agreements is to identify the type of lease involved. There are two main types of leases – operating leases and finance leases (also known as capital leases). Operating leases are typically used for short-term leases of equipment that are not expected to last beyond the lease term. Finance leases, on the other hand, are used for longer-term leases and are considered as a form of financing.
When it comes to lease purchase agreements, it is almost always the case that they will be classified as finance leases. This is because the lessee will ultimately have the option to purchase the equipment at the end of the lease term, which means that the lessor is essentially providing financing to the lessee.
2. Recognize the lease liability and asset
Once you have identified the type of lease, the next step is to recognize the lease liability and asset on the balance sheet. The lease liability represents the obligation to make lease payments over the lease term, while the lease asset represents the right to use the leased equipment over the same period.
To calculate the lease liability, you will need to determine the present value of the lease payments over the lease term. This can be done using the lessee`s incremental borrowing rate or the lessor`s implicit rate. The lease asset, on the other hand, is calculated as the present value of the lease payments plus any initial direct costs incurred by the lessee.
3. Recognize the interest expense and depreciation
Finally, you will need to recognize the interest expense and depreciation related to the lease. The interest expense represents the cost of the lease financing, and is calculated using the effective interest rate method. This involves applying the interest rate implicit in the lease to the remaining lease liability balance.
Depreciation, on the other hand, represents the systematic allocation of the lease asset over the lease term. The depreciation method used will depend on the nature of the equipment being leased and the expected pattern of its use over the lease term.
In conclusion, accounting for lease purchase agreements requires careful consideration of the type of lease involved, as well as the recognition of the lease liability and asset, interest expense, and depreciation. By understanding the basics of lease accounting, businesses can make informed decisions and accurately reflect the financial impact of these agreements on their balance sheets.