I am able to understand the calculations for a finance lease - however, I am not able to see how the book values (when increasing as asset) and the lease liability (when increasing the liability) balances for each of the given year. I have tried working through the I/S by including RE since both the depreciation and interest expenses are impacted - yet still they do not balance. Can you please provide some guidance? Thanks. References: 1) Schweser FRA, pg. 52, “Example: Accounting for a finance lease”, 2) CFAI FRA, pg. 100, Example 13
I think you are talking about how a finance lease impacts the balance sheet as it is paid? The detail I am giving below is not included in Schweser/CFAI, but since you are curious… Assume you create a finance lease, total value of $50,000 over the 10 year term of the lease, and PV of $33,795. Create a lease liability and asset on the balance sheet. Assets: $33,795 (lease asset) Liabilities $33,795 (lease liability) Asset is depreciated through increased accumulated depreciation, depreciation expense in NI, lower retained earnings. Assets decline and retained earnings decline. For lease liability: Cash is decreased every year by amount of lease payment owed (say $5,000). RE is decreased by interest expense (say $3,000) through lower NI, Interest Payable goes down by $3,000, Accrued Interest Payable (contra-liability) goes up by $3,000, lease liability goes down by part of the payment that is principal $2,000. Assets decline by 5,000, Liabilities and Equity decline by a total of 5,000. Notice that depreciating the asset and amortizing the liability balance completely independently of each other Cheers.
Thanks - I know that RE is probably causing a heck of a confusion for me. I like the example you’ve given, but for the sake of others can we please work through a real Schweser example - FRA book pg. 53 - I will summarize for those who don’t have access: A company leases a machine with an end of the year annual pmt. of $10,000 for 4 years with a 6% interest. So, we know that: PV = $34,651 Annual dep exp = $8,663 Let’s work through just the first two years as they will be the same for the remaining two. Now, onto the B/S and I/S: ------------------------Year 1-----------Year 2 PPE-------------------34,651------------25,988 Dep-------------------(8,663)-----------(8,663) Carrying value------25,988------------17,326 Cash-----------------(10,000)----------(10,000) Total Asset-----------15,988------------7,326 Lease liability-------34,651------------26,730 Interest exp---------(2,079)-----------(1,604) Lease payable-----(10,000)---------(10,000) Net lease liability—26,730-----------18,334 Retained earnings-(10,742)--------(10,267) Total L + E:-----------15,988------------8,068 I/S Dep expense:-------(8,663)-----------(8,663) Int expense:--------(2,079)-----------(1,604) Finance lease exp-(10,742)---------(10,267) If you look at Year 2 totals, the difference is by $742 which is the amount over by the lease payment in Year 1 - but how does that transfer over to RE in year 2? Or am I looking at this completely wrong?
Don’t think about this in terms of adding them all together to get total Assets, Liabilities, and Equities. Since this is only a partial balance sheet, looks at the changes in A, L & E. As long as the changes in both sides are equal, the total statement will balance. Below is how everything will look after one year. ------------------------Year 1 PPE-------------------34,651 Acc Depr-------------(8,663) Cash-----------------(10,000) Chng in Total Asset–(18,633) Lease liability---------26,730
Thanks - your logic is absolutely correct. I should be only checking whether the delta is the same on both sides of the equation. I noticed though that ‘Interest Payable’ and ‘Accumulated Interest Payable’ has to cancel each other out in order for the balance to occur. So, if we treat them in the same fashion for all of the other years as we did in Year 1 there should be no issues. But in reality, how are they really treated as the accumulated interest increases over time and the interest payable decreases? Is there another way of stating these while keeping both sides balanced? Thanks.