Financial Accounting · Lease Accounting

Accounting for Finance Leases in Books of Lessee

Updated 10 October 2026 · Fact-checked

In a finance lease, the lessee records the leased asset and a lease liability at inception, at the lower of fair value and present value of minimum lease payments. Each payment is split into finance charge and reduction of liability using a constant rate. The lessee also charges depreciation on the asset. To solve: build the schedule, then post entries.

Understand Accounting for Finance Leases in Books of Lessee

A lease is an agreement where the lessor gives the lessee the right to use an asset for an agreed period in return for a payment or series of payments. A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of the asset. The lessee in such a lease is treated almost as if it had bought the asset with a loan.

So at inception, the lessee shows the asset and the liability in its balance sheet. Under AS 19 (para 11), the amount is the fair value of the leased asset. If the fair value is more than the present value of the minimum lease payments (from the lessee's side), the present value is used instead. Both the asset and the liability are recorded at the same amount at the start (para 13).

The discount rate is the interest rate implicit in the lease, if it is practicable to find it. If not, you use the lessee's incremental borrowing rate, which is the rate the lessee would pay on a similar lease, or to borrow the funds needed to buy the asset.

Each lease payment has two parts. One part is the finance charge and the other reduces the outstanding liability. The finance charge is allocated so that it gives a constant periodic rate on the remaining liability (para 16). That is why you build a schedule: interest is always the opening liability × the rate.

The lessee also charges depreciation on the asset, consistent with its owned assets (para 18). If there is no reasonable certainty that the lessee will get ownership by the end of the lease term, the asset is fully depreciated over the lease term or its useful life, whichever is shorter. The P&L therefore shows depreciation plus finance charge, not the rent paid (para 20). This is the main point examiners test.

Key rules to remember

Initial recognition amount: Asset = Liability = lower of (Fair value, PV of minimum lease payments); PV is from the lessee's standpoint. Use the implicit rate if practicable, otherwise the incremental borrowing rate.
Present value of payments: PV = Σ Payment ÷ (1 + r)ⁿ, plus PV of any guaranteed residual value; Use the discount factors given in the question. Include the residual value the lessee has guaranteed.
Finance charge for a period: Finance charge = Opening liability × implicit rate; If the payment is made at the end of the year, interest runs on the full opening balance.
Reduction in liability: Reduction = Lease payment − Finance charge; Closing liability = Opening liability − Reduction.
Depreciation when ownership is not certain: Depreciation per year = (Asset value − expected residual value) ÷ shorter of lease term and useful life; Where ownership is reasonably certain, use the useful life instead. Follow the depreciation method used for owned assets.
Total charge to P&L over the lease: Total depreciation + Total finance charge = Total lease payments (when there is no residual value); Use this as a quick check of your schedule.

How to solve Accounting for Finance Leases in Books of Lessee questions

Follow this order for any lessee question on finance leases. It keeps your working clean and earns step marks.

1Confirm the lease is a finance lease from the facts given, such as the lease covering the whole economic life, or an ownership transfer.
2Find the amount to recognise: compare fair value with the present value of minimum lease payments (including any guaranteed residual value) and take the lower.
3Pass the opening entry: Asset A/c Dr. and To Lessor (Lease Liability) A/c at that amount.
4Prepare the schedule with columns: opening liability, finance charge, payment, reduction in liability, closing liability. Interest = opening liability × rate.
5Check the schedule: the closing liability after the last payment should be nil, or equal to the guaranteed residual value if one exists. Small differences come from rounding the rate.
6Calculate depreciation as for an owned asset, over the lease term or useful life as the facts require.
7Pass each year's entries: finance charge, payment to lessor, and depreciation. Then show the P&L charge and the balance sheet liability, split into current and non-current if asked.
8Write the answer in a neat table and give a one-line interpretation, such as: the P&L charge is not equal to the rent paid.

Quickest way: Schedule-first method for MCQs and short problems

When to use it: Use this when time is short and the question gives the rate and payments, so that you only need one year's figure or the closing liability.

Write the recognised amount first, so that the lower-of test is done and the opening balance is fixed.
For year 1 only: interest = opening × rate, principal = payment − interest, closing = opening − principal.
For year 2 onwards, repeat from the previous closing balance. Do not use the original amount again.
Depreciation is simply (recognised amount − residual) ÷ years. Add it to interest for the P&L charge.
Check: the last closing balance should be nil, or equal to the guaranteed residual value.

Common mistakes in Accounting for Finance Leases in Books of Lessee

Charging the full lease rent to the P&L as an expense.
Students treat it as an operating lease and mix up the rent with the expense.
Fix: For a finance lease, charge only depreciation and finance charge. The payment itself reduces the liability, as para 20 explains.
Recording the asset at the fair value even when the present value of the minimum lease payments is lower.
The lower-of rule in para 11 is missed.
Fix: Always compute both figures and take the lower one for both the asset and the liability.
Calculating the finance charge on the original liability every year.
Students copy the first year's interest down the column.
Fix: Interest is always the opening balance of that year × rate. The balance falls each year, so interest falls too.
Ignoring the guaranteed residual value in the present value and the closing balance.
Students look at the annual payments only.
Fix: Include the PV of the guaranteed residual value in the minimum lease payments. After the last payment, the liability should equal that residual value, which is then settled.
Depreciating over the useful life when ownership is not certain.
Students apply the owned-asset rule without reading the lease terms.
Fix: If there is no reasonable certainty of getting ownership, depreciate fully over the shorter of lease term and useful life (para 18).
Treating the first payment as at the end of the year when it is actually made at the start.
The timing of payment is not read carefully.
Fix: Check the timing. For payment at the start, reduce the liability by the payment first, then charge interest on the balance.

Worked examples

Example 1

Meera Textiles Ltd. takes a machine on lease from Kaveri Leasing Ltd. The lease is for 3 years, which is the whole economic life of the machine. The fair value of the machine is ₹2,60,000. The lessee pays ₹1,00,000 at the end of each year. The interest rate implicit in the lease is 10%, and the present value of an annuity of ₹1 for 3 years at 10% is 2.48685. There is no residual value, and ownership does not pass to the lessee. Prepare the lease liability schedule and show the total charge to the statement of profit and loss for each year. Use straight-line depreciation.

Show the solution

Present value of minimum lease payments = ₹1,00,000 × 2.48685 = ₹2,48,685.
Fair value is ₹2,60,000, which is more than ₹2,48,685. So the asset and liability are recorded at the lower amount, ₹2,48,685 (para 11).
Opening entry: Machinery A/c Dr. ₹2,48,685; To Kaveri Leasing Ltd. ₹2,48,685.
Year 1: finance charge = 10% × 2,48,685 = ₹24,869 (rounded). Reduction = 1,00,000 − 24,869 = ₹75,131. Closing liability = 2,48,685 − 75,131 = ₹1,73,554.
Year 2: finance charge = 10% × 1,73,554 = ₹17,355. Reduction = 1,00,000 − 17,355 = ₹82,645. Closing liability = 1,73,554 − 82,645 = ₹90,909.
Year 3: finance charge = 10% × 90,909 = ₹9,091. Reduction = 1,00,000 − 9,091 = ₹90,909. Closing liability = nil.
Check: total finance charge = 24,869 + 17,355 + 9,091 = ₹51,315, and total payments less amount recognised = 3,00,000 − 2,48,685 = ₹51,315.
Depreciation: ownership is not certain, so depreciate over the lease term of 3 years. ₹2,48,685 ÷ 3 = ₹82,895 per year.
Charge to P&L: Year 1 = 82,895 + 24,869 = ₹1,07,764. Year 2 = 82,895 + 17,355 = ₹1,00,250. Year 3 = 82,895 + 9,091 = ₹91,986. The total is ₹3,00,000, which equals the total payments.

Answer: Asset and liability at inception: ₹2,48,685. Closing liability: ₹1,73,554 (Year 1), ₹90,909 (Year 2), nil (Year 3). Finance charge: ₹24,869, ₹17,355, ₹9,091. P&L charge: ₹1,07,764, ₹1,00,250, ₹91,986.

Example 2

Arjun Engineering Ltd. leases a press on 1 April 2026 for 2 years, which is its whole useful life. The fair value of the press is ₹1,69,005. The lessee pays ₹1,00,000 at the end of each year (31 March 2027 and 31 March 2028). The implicit rate is 12%, and there is no residual value. The lessee depreciates on the straight-line method. Pass the journal entries for the year ended 31 March 2027 and state the lease liability at that date.

Show the solution

Present value of payments at 12%: 1,00,000 × 0.892857 + 1,00,000 × 0.797194 = 89,286 + 79,719 = ₹1,69,005 (rounded). This equals the fair value, so the asset and liability are recorded at ₹1,69,005.
Opening entry on 1 April 2026: Press A/c Dr. ₹1,69,005; To Lessor A/c ₹1,69,005.
Finance charge for year 1 = 12% × 1,69,005 = ₹20,281 (rounded). Entry: Finance Charges A/c Dr. ₹20,281; To Lessor A/c ₹20,281.
Payment on 31 March 2027: Lessor A/c Dr. ₹1,00,000; To Bank A/c ₹1,00,000.
Depreciation = 1,69,005 ÷ 2 = ₹84,503 (rounded). Entry: Depreciation A/c Dr. ₹84,503; To Press A/c ₹84,503.
Closing liability = 1,69,005 + 20,281 − 1,00,000 = ₹89,286.
Check: the final payment of ₹1,00,000 will include interest of 12% × 89,286 = ₹10,714 and principal of ₹89,286. So the whole liability is due within 12 months, and it is shown as a current liability.
Closing book value of the press = 1,69,005 − 84,503 = ₹84,502. Finance charges and depreciation are transferred to the P&L.

Answer: Entries: Press ₹1,69,005 / Lessor ₹1,69,005; Finance Charges ₹20,281 / Lessor ₹20,281; Lessor ₹1,00,000 / Bank ₹1,00,000; Depreciation ₹84,503 / Press ₹84,503. Lease liability on 31 March 2027: ₹89,286 (current).

Exam tips

Always start with the lower-of test. Many MCQs hide the trap in a fair value that is higher than the present value.
Write the schedule in the standard five-column format, even for one-mark steps. It lets the examiner give marks for the method even if rounding differs.
Check the last closing balance. If it is not nil (or the guaranteed residual value), find your slip before moving on. The standard itself notes that small differences arise from approximating the rate.
Read the facts for ownership. They decide whether depreciation runs over the lease term or the useful life.
Show the P&L charge as depreciation plus finance charge, and state clearly that it is not the same as the rent paid.

Practice questions from Lease Accounting

Accounting for Finance Leases in Books of Lessee in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Accounting for Finance Leases in Books of Lessee: frequently asked questions

At what amount does the lessee record a finance lease?

The lessee records the asset and the liability at the fair value of the leased asset at inception. If the fair value is higher than the present value of the minimum lease payments from the lessee's standpoint, the present value is used. The same amount is used for both the asset and the liability.

Which discount rate should the lessee use?

Use the interest rate implicit in the lease if it is practicable to determine. If it is not, use the lessee's incremental borrowing rate. In exam questions, the rate is usually given or can be taken from the data.

How is the lease payment split in the books of the lessee?

Each payment is split into a finance charge and a reduction of the outstanding liability. The finance charge is the opening liability × the rate, so that the rate on the remaining balance stays constant. The remaining part of the payment reduces the liability.

Over what period is a leased asset depreciated?

The depreciation policy should be consistent with that for owned depreciable assets. If there is no reasonable certainty that the lessee will get ownership by the end of the lease term, the asset is depreciated fully over the lease term or its useful life, whichever is shorter.

Why is the P&L charge different from the rent paid?

The lessee charges depreciation and finance charge, not the rent. The sum of these two is rarely equal to the payment for the period, so the standard says it is inappropriate to just charge the lease payments as an expense.