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Welcome back. In this lesson,
we're going to start talking about subsequent measurement,
what you account for after the commencement of the lease.
And we'll start with finance leases.
So, the subsequent measurement of
the obligation is the same for finance and operating leases.
The subsequent measurement of course of the right to use asset will different,
the reconciling anonymous income,
but we're starting with financing leases,
these are actually the easier of the two now.
So the lease obligation is amortized the same as installment debt.
So, a monthly lease payment will be composed of
interest expense and the reduction of the lease obligation.
Let's look at an example of how that would work.
Recall that we measured the lease obligation for Cybercrime System as an annuity due.
That means the first payment is all a reduction of principal.
We haven't incurred any interest yet because it's being paid on the first day.
So that day one entry for $9,887 is just going to
be all a reduction of the obligation, reduction of principle.
Now subsequent to that,
we're going to include interest expense.
And the interest expense is going to be higher in the initial periods,
and declining over the lease term. Why is that?
Well, it's because if we're multiplying the effective rate in the lease,
that incremental borrowing rate or the rate implicit in the lease,
we're multiplying that times a declining balance of principle,
so the amount of interest is declining.
So that means that the expense will be higher in the initial periods,
and declining over the lease term.
This will be true for both financing and operating leases.
The right-of-use asset, though,
is going to be depreciated like
the underlying asset over the shorter of its useful life or the lease term.
So in our example, we had an initial carrying value of 861,000.
If we depreciate that over 120 months,
it is $7,175 a month.
So the journal entry at the end of the accounting period will record
the depreciation expense for the final month of 7,175,
but you're also going to accrue interest on the outstanding obligation for the month.
We've got a payment that's going to be due the first of January,
so I'm going to make an accrual at the end
of December for the interest expense portion of that debt.
Now this is just like what we were doing with current liabilities.
In fact, it's going to be the exact same procedure for
calculating the amount of interest expense to accrue.
So, on the next day,
when we make the payment, of course,
we'll reverse that accrued interest,
and now we will reduce the lease obligation.
Notice we didn't accrue an amount for the lease obligation in the accrual period.
That's only reduced when we actually make the payment but the interest is accrued in
the period in which the interest expense is
incurred and we'll recognize again the cash payment at that point.
So, at the end of the year once again,
we're going to accrue interest as a current liability.
We're not going to accrue interest for the non-interest portion,
we'll continue to recognize the monthly depreciation expense. So what happens?
Because a finance lease is accounted for as an installment debt,
again that interest expense is higher in the initial period,
it declines over the lease term.
So, you get a pattern of expense recognition where
the expenses higher in the earlier periods and declines as you go through the lease.
This is considered to be a drawback to finance lease accounting,
and in fact it's the reason why the FASB
elected to retain operating lease classification.
We will show you in a few minutes how that's different.
What about the statement of cash flows?
Well the portion of lease payments that's attributable
to interest is usually classified as cash from operations,
and the portion of lease payments that reduces
the lease obligation is classified as a financing cash flow.
Just like under current gap,
that right-of-use asset will be subject to impairment testing.
A lot of times it won't be possible to test the leased asset individually by itself,
something like a total aid that we have here.
Usually, it will be included as part of a larger group of assets,
and then the loss for the group,
if there is one, would be allocated to
the individual assets and that would include the ROU asset.
So, that's the basic accounting model for a finance lease.
It's relatively simple, it's accounted for just like it's debt,
and it has all the issues that you would expect with debt.
You use the effective interest rate method to calculate interest expense,
you will accrue interest expense at the end of the period if necessary,
and you will account for the obligation,
reduction the obligation when you make the cash payment. Thank you.
John HeppClinical Assistant Professor of Accountancy
