Module 9-DIRECT FINANCING LEASE - LESSOR
Module 9-DIRECT FINANCING LEASE - LESSOR
Module No. 9
Subject: Intermediate Accounting 2 Date of Submission: ____________
Name of Student: __________________________________________________
Course and Year: __________________________________________________
Semester and School Year: __________________________________________
a. Direct financing
b. Sales type lease
The main distinction between the two is the presence or absence of manufacturer or dealer profit or loss. A direct
financing lease recognizes only interest income. A sales type lease recognizes interest income and gross profit on sale.
The lessor in a direct financing lease is actually engaged in the financing business. Thus, a direct financing lease is an
arrangement between a financing entity and a lessee. The income of the lessor is only in the form of interest income.
No dealer profit is recognized because the fair value and the cost of the asset are equal.
Accounting consideration
a. Gross investment – this is equal to the gross rentals for the entire lease term plus the absolute amount of the
residual value, whether guaranteed or unguaranteed.
b. Net investment in the lease – This is equal to the cost of the asset plus any initial direct cost paid by the lessor.
c. Unearned interest income – This is the difference between the gross investment and net investment in the lease.
d. Initial direct cost – in a direct financing lease, the initial direct cost paid by the lessor is added to the cost of the
asset to get the net investment in the lease.
The initial direct cost would effectively spread the initial direct cost over the lease term and reduce the amount of
interest income.
On January 1, 2020, Lessor Company leased a machinery to another entity with the following details:
The initial problem is the determination of the annual rental which will give the lessor a fair rate of return on the net
investment in the lease.
The procedure is to divide the “net investment in the lease to be recorded from rental” by present value factor of an
annuity of 1 for a number of periods using a desired rate of return to get annual rental.
Computation
Cash 500,000
Lease receivable 500,000
Table of amortization
The unearned interest income of P481,350 is recognized over the lease term following the effective interest method.
Interest is equal to the preceding present value times the interest rate. Thus, for 2020, P1,518,650 times 12% equals
P317,762.
Principal is the portion of the rental payment after deducting the interest. Thus, for 2020, P500,000 minus P182,238
equals P317,762.
Present value is the balance of the present value after deducting the principal payment.
The effective interest method is used in recognizing interest income. IFRS 16, paragraph 75, states that the lessor shall
recognize finance income over the lease term based on a pattern reflecting a constant periodic rate of return on the
lessor’s net investment in the lease.
2020
Dec. 31 Unearned interest income 182,238
Interest income 182,238
2021
Dec. 31 Unearned interest income 144,107
Interest income 144,107
The initial direct cost is added to the cost of the machinery to determine the net investment in the lease.
The conclusion of initial direct cost in the net investment in lease will have the effect of spreading the initial direct cost
over the lease term and reduced the interest income from the finance lease.
Consequently, the initial direct cost would decrease implicit interest rate in the lease.
The problem therefore is the determination of the reduced implicit interest rate.
The original implicit interest rate of 12% cannot be applied anymore because of the added initial direct cost.
The new implicit rate is computed by trial and error or through the interpolation process.
The new interest rate is definitely lower than 12% and it could be 11%, 10% or 9%.
The procedure is determine the present value of gross rentals that would equate the net investment in the lease of
P1,584,950 using a particular rate.
Using 11% the present value of an ordinary of 1 at 11% for 4 periods is 3.1024.
Thus, the present value of gross rentals is equal to P500,000 multiplied by 3.1024 or P 1,551,200.
This amount is not the same as the net investment in the lease. The new interest rate is not 11%.
Using 10%, the present value of an ordinary annuity of 1 at 10% for 4 periods is 3.1699.
Thus, the present value of gross rentals is equal to P500,000 multiplied by 3.1699 or P1,584,950.
Coincidentally, this amount is the same as the net investment in the lease.
Accordingly, the reduce interest rate of 10% is used in determining the annual interest income.
Journal entries
Cash 500,000
Lease receivable 500,000
The unearned interest income of P415,050 is recognized as income over the lease term following the effective interest
method of amortization.
Table of amortization
Interest is equal to the preceding present value times the interest rate.
Principal is the portion of the rental payment after deducting the interest.
Present value is the balance of the preceding value after deducting the principal payment.
Journal entries
The recognition of interest income for the first two years is recorded as:
2020
2021
If a statement of financial position is prepared by the lessor on December 31, 2020, the lease receivable of P1,500,000
would be reported as partly current and partly noncurrent.
Current portion
Lease receivable 500,000
Unearned interest income (124,344)
Carrying amount 375,656
IFRS 16, paragraph 67, states that lessor shall recognize assets held under a finance lease as a receivable at an amount
equal to the net investment in the lease.
Note that the unearned interest income which is realizable within one year from December 31, 2020 is deducted from
the current lease receivable.
On January 1, 2020, Lessor Company leased a machinery to another entity with the following details:
The machinery will revert to the lessor at the end of the lease term because there is neither a transfer of title nor a
purchase option.
The problem is the determination of the annual rental. The annual rental is payable at the end of each year with the first
payment on December 31, 2020. The relevant present value factors are:
Note that the present value of the residual is deducted from the cost of the asset if the machinery will revert to the
lessor at the end of the lease term.
Otherwise, if the machinery will not revert to the lessor at the end of the lease term, the residual value is completely
ignored.
Table of amortization
Interest is equal to the preceding present value times the interest rate. Thus, for 2020, P3,194,410 times 10% equals
P319,441.
Present value equals the balance of the present value minus the principal payment.
Cash 900,000
Lease receivable 900,000
When the lease expires on December 31, 2023, the machinery will revert to the lessor.
Whether “guaranteed” or “unguaranteed”, the entry on the book of the lessor will be the same.
Machinery 500,000
Lease receivable 500,000
Accounting problem
The accounting problem is when the fair value of the machinery is P400,000 which is Lower than the residual value of
P500,000.
Under the guaranteed scenario, the lessee will pay the difference. The journal entry of the lessor is:
Cash 100,000
Machinery 400,000
On January 1, 2020, Lessor Company leased a machinery to another entity with the following details:
The annual rental is payable in advance on January 1 of each year starting January 1, 2020.
Since the residual value is guaranteed, the machinery will revert to the lessor at the end of the lease term.
Note that the rental is payable in advance at the beginning of each year. Thus, the “annuity of 1 in advance factor” is
used in the computation.
Interest is equal to the preceding present value times the interest rate. The first rental payment on January 1, 2020
pertains to principal only.
Thus, on January 1, 2021, the interest is equal to P2,760,100 times 10% or P276,010. This interest income pertains to
2020.
Principal is the portion of rental payment minus the interest. Thus on January 1, 2021, P1,000,000 minus P276,010
equals P723,990.
Present value is the balance of the present value minus the principal payment.
Journal entries
1 Cash 1,000,000
Lease receivable 1,000,000
2021
Jan. 1 Cash 1,000,000
Lease receivable 1,000,000
2022
Jan. 1 Cash 1,000,000
Lease receivable 1,000,000
2023
Jan. 1 Cash 1,000,000
Lease receivable 1,000,000
2024
Jan. 1 On this date, deferred value of the machinery is P300,000 only. Since
the guaranteed residual value is P400,000, the lessee will pay for the
differences of P100,000.
Cash 100,000
Machinery 300,000
Lease receivable 400,000
On January 1, 2020, Lessor Company leased a machinery to another entity with the following details:
The annual rental payable in advance on January 1 of each year starting January 1, 2020. The lease provides for a
transfer of title to the lessee at the end of the lease term.
Note well that if the machinery will not revert to the lessor at the of the lease term because the lease provide 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.
Thus, the annuity of 1 in advance or annuity due factor is used in the computation.
Table of amortization
Interest is equal to the preceding present value times the interest rate. The first rental payment on January 1,2020
pertains to principal only. Thus, on January 1, 2021 the interest is equal to P2,649,600 times 8% or P211,968. This
interest income pertains to 2020/
Principal is the portion of the rental payment minus the interest. Thus, on January 1, 2021, P800,000 minus P211,968
equals P588,032.
Present value is the balance of the present value minus the principal payment. Thus, January 2021, P2,649,600 minus
P588,032 equals P2,061,568.
2020
Jan. 1 Lease receivable 4,000,000
Machinery 3,449,600
Unearned interest income 550,400
1 Cash 800,000
Lease receivable 800,000
2021
Jan. 1 Cash 800,000
Lease receivable 800,000
References
Valix, C. & Valix, C.A. (2018). Practical Accounting 1 vol 2. GIC Enterprises and Co., Inc. Manila, Philippines
Valix, C. & Valix, C.A. (2013). Theory of Accounts 2013 edition. GIC Enterprises and Co., Inc. Manila, Philippines
Robles, N. & Empleo P. (2016). The Intermediate Accounting Series Vol 2. Millenium Books, Inc., Mandaluyong City
Uberita, C. (2012). Practical Accounting 1 2013 Edition. GIC Enterprises and Co, Inc. Manila, Philippines