DIRECT FINANCING LEASE-LESSOR

Classification
a. Direct Financing Lease
- Lessor is actually engaged in the financing business.

Gross rental = gross rental + residual value (whether guaranteed or

unguaranteed)
= debited to gross receivable
Net investment = cost of the asset + initial direct cost
= credited to lease asset account

Unearned income = gross investment – net investment

Note: Initial direct cost paid by the lessor is added to the cost of the asset
to get the net investment in the lease. Accordingly, the
interest rate implicit in the lease is recomputed so as to
include the initial direct cost in the measurement of lease
receivable.

Sample Problem

Case 1

On January 1 2015, Mari Company leased an equipment to Pau Company with the
following details:
Cost of equipment P 759,325
Annual rental payable at the of
each year 250,000
Lease term 4 years
Useful life of machinery 4 years
Implicit interest rate 12%
Present value of annuity of 1 for
4 years a 12% 3.0373

Gross rentals or lease receivable (250,000 x 4 yrs) 1,000,000

Present value of gross rentals 759,325
--------------
Unearned interest income 240,675
========
January 1, 2015
Lease receivable 1,000,000
Equipment 759,325
Unearned interest revenue 240,675

Applicable Carrying
Date Payment Interest(12%) to Principle Value
1/1/15 759,325
12/31/15 250,000 91,119 158,881 600,444
12/31/16 250,000 72,053 177,947 422,497
12/31/17 250,000 50,700 199,300 223,197
12/31/18 250,000 26,803 223,197 -

December 31, 2015

Cash 250,000
Lease receivable 250,000

Unearned interest revenue 91,119

Interest revenue 91,119
Case 2

Assuming on January 1, 2015, Mari Company paid initial direct cost of P33,150 In
connection with negotiating and arranging the lease
Cost of equipment P 759,325
Initial direct cost 33,150
---------------------
Net investment P 792,475
============

Gross rentals P 1,000,000

Net investment 792,475
-----------------------
Unearned interest revenue 207,725
=============

Present value rate = 792,475/250,000

= 3.1699; under PV table 10%, 4 periods

January 1, 2015

Equipment 33,150
Cash 33,150

`= Lease receivable 1,000,000

` Equipment 792,475
Unearned interest revenue 207,725

Effective Applicable to Carrying

Date Payment Interest Principal Value
01/01/2015 792,475
12/31/2015 250,000 79,248 170,752 621,723
12/31/2016 250,000 62,172 187,828 433,895
12/31/2017 250,000 43,390 206,610 227,285
12/31/2018 250,000 22,715 227,285 -

December 31, 2015

Cash 250,000
Lease receivable 250,000

Unearned interest revenue 79,248

Interest revenue 79,248

Direct Financing Lease with Residual Value

1. The present value of the residual value is deducted from the cost of the asset if
the leased asset will revert to the lessor at the end of lease term. Otherwise, if
the leased equipment will not revert to the lessor at the end of the lease term,
the residual value is completely ignored.
2. Under the guaranteed scenario, the lessee will pay the lessor if the FMV of
Leased asset is lower that the residual value at the end of lease term.
Cash xxx
Leased asset xxx
Lease receivable xxx
3. However, under the unguaranteed scenario, the lessor shall recognize a loss if
the FMV of leased asset is lower than the residual value at the end of lease term,
 Loss on finance lease xxx
Leased asset xxx
Lease receivable xxx
4. If the residual value is guaranteed, the leased asset will revert to the lessor at the
end of lease term.
5. If the leased asset will not revert to the lessor at the end of the lease term
because the lease provides for a transfer of title to the lessee, the residual value
is completely ignored in the computation of the annual rental and the unearned
interest income

Title not transferred to the lessee at the end of lease term

Net investment to be recovered = cost of machinery (PV of rental payment) – PV

of residual value

Annual rental = Net investment to be recovered/ PV rate

Gross Investment = Gross rental + Residual value whether guaranteed or

Unguaranteed

Unearned interest revenue = Gross investment – Net investments ( Cost of

Machinery)

Illustrative Problems

On January 1, 2015, Mari Company leased a machinery to Camil Company with the
following details:
Cost of equipment P 6,388,820
Residual value 1,000,000
Useful life 4 yrs
Lease term 4 yrs
Implicit interest rate 10%
PV of 1 at 10% for 4 periods .6830
PV of an ordinary annuity of 1 at 10%
for 4 periods 3.1699

Cost of lease equipment P 6,388,820

PV of residual value (1,000,000 x .6830) 683,000
------------------------
Net investment to be recovered 5,705,820
Divide by PV 3.1699
------------------------
Annual rental P 1,800,000
==============

Gross rentals (1,800,000 x 4) 7,200,000

Residual value (whether guaranteed or
unguaranteed) 1,000,000
------------------------
Gross investment 8,200,000
==============

Gross investment P 8,200,000

Cost of machinery 6,388,820
-----------------------
Unearned interest revenue P 1,811,180
=============

Leased receivable 8,200,000

Leased equipment 6,388,820
Unearned interest revenue 1,811,180
 Effective Applicable Carrying
Date Payment interest to Principal Value
1/1/2015 6,388,820
12/31/2015 1,800,000 638,882 1,161,118 5,227,702
12/31/2016 1,800,000 522,770 1,277,230 3,950,472
12/31/2017 1,800,000 395,047 1,404,953 2,455,519
1/31/2018 1,800,000 344,481 1,455,519 1,000,000

December 31, 2015

Cash 1,800,000
Lease receivable 1,800,000

Unearned interest revenue 638,882

Interest revenue 638,882

Entry at the end of lease term assuming the FMV of leased asset is P900,000.
Unguaranteed RV
Leased equipment 900,000
Loss on finance lease 100,00
Lease receivable 1,000,000

or

Guaranteed RV
Leased equipment 900,000
Cash 100,000
Lease receivable 1,000,000

Title revert to the lessor at the end of lease term ( ignore residual value whether
guaranteed or unguaranteed in the computation of both the annual rental and Unearned
interest income.

Net investment to be recovered = cost of equipment or net investment

Gross investment = Gross rental

Unearned interest revenue = Gross investment – net investment