CHAPTER 13

DIRECT FINANCING LEASE

Finance lease on the part of the lessor is either:
1. Direct financing lease-
a. Lessor is actually engaged in the financing business
b. An arrangement between a financing entity and a lessee.
c. Recognizes only interest income
d. No dealer profit is recognized because the fair value and the cost of the asset are
equal.
2. Sales type lease – (Discussed in Chapter 14)
a. Recognizes interest income and gross profit on sale

Illustration – Direct Financing Lease

Jan., 1, 2020, Lessor leased a machinery to another entity with the following details
Cost of machinery 1,518,650
Annual rental payable at the end of each year 500,000
Lease term 4 years
Useful life of machinery 4 years
Implicit rate of interest 12%
PV of annuity of 1 for 4 years at 12% 3.0373

Compute the annual rental;

Cost of machinery 1,518,650
Divide by PV factor 3.0373
Annual rental 300,000

Gross rentals or lease receivable (500,000 x 4 years) 2,000,000

PV of gross rentals (net investment in the lease
or cost of machinery 1,518,650
Unearned interest income 481,350

Journal entries
Lease receivable 2,000,000
Machinery 1,518,650
Unearned interest income 481,350

Cash 500,000
Lease receivable 500,000
Annual collection of rental

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AMORTIZATION TABLE

Date Payment 12% Interest Principal Present value

1/1/20 1,518,650
12/31/20 500,000 182,238 317,762 1,200,888
12/31/21 500,000 144,107 355,893 844,995
12/31/22 500,000 101,399 398,601 446,394
12/31/23 500,000 53,606 446,394 -

Entries for interest income is based on the table

12/31/2020 Unearned interest income 182,238

Interest income 182,238

Direct Financing with Initial Direct Cost

Jan., 1, 2020, Lessor leased a machinery to another entity with the following details
Cost of machinery 1,518,650
Annual rental payable at the end of each year 500,000
Lease term 4 years
Useful life of machinery 4 years
Implicit rate of interest 12%
PV of annuity of 1 for 4 years at 12% 3.0373

On Jan. 1, 2020 – Lessor Company paid initial direct cost of P66,300.

Net investment in the lease is:
Cost of machinery 1,518,650
Initial direct cost 66,300
Net investment in the lease 1,584,950

Gross rentals or lease receivable (500,000 x 4 years) 2,000,000

Net investment in the lease or cost of machinery 1,584,950
Unearned interest income 415,050

The original implicit rate of 12% cannot be applied anymore because of the added initial direct
cost. The new implicit interest rate would be 10% applying the interpolation.
(See page 433 for computation)

Journal entries:
Machinery (initial direct cost) 66,300
Cash 66,300

Lease receivable 2,000,000

Machinery 1,584,950
Unearned interest income 415,050

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 Cash 500,000
Lease receivable 500,000
Annual collection of rental

AMORTIZATION TABLE

Date Payment 10% Interest Principal Present value

1/1/20 1,584,950
12/31/20 500,000 158,495 341,505 1,243,445
12/31/21 500,000 124,344 375,656 867,789
12/31/22 500,000 86,779 413,221 454,568
12/31/23 500,000 45,432 454,568 -

Entries for interest income is based on the table

SFP Presentation
Current portion
Lease receivable 500,000
Unearned interest income (124,344)
Carrying amount 375,656

Noncurrent portion
Lease receivable 1,000,000
Unearned interest income (132,211)
Carrying amount 867,789

Direct Financing lease with residual value

Jan., 1, 2020, Lessor leased a machinery to another entity with the following details
Cost of machinery 3,194,410
Residual value 500,000
Useful life and lease term 4 years
Implicit rate of interest 10%

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.

PV of 1 at 10% for 4 periods .6830

PV of an ordinary annuity of 1 at 10% for 4 periods 3.1699

Determine the annual rental:

Cost f machinery 3,194,410
PVS of residual; value (500,000 x .683) (341,500)
Net investment to be recovered from rental 2,852,910
Divide by PV factor of ordinary annuity of 1
at 10% for 4 periods 3.1699
Annual rental 900,000

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Note:
 PV of residual value is deducted from the cost of the asset if the machinery will revert back to
the lessor.
 If the machinery will not revert back to the lessor, the residual value is completely ignored,
hence:
Gross rentals (P900,000 x 4) 3,600,000
Residual; value (whether guaranteed or not) 500,000
Gross investment 4,100,000
Cost of machinery-net investment (3,194,410)
Unearned interest income 905,590

Date Payment 10% Interest Principal Present value

1/1/20 3,194,410
12/31/20 900,000 319,411 580,559 2,613,851
12/31/21 900,000 261,385 638,615 1,975,236
12/31/22 900,000 197,524 702,476 1,272,760
12/31/23 900,000 127,240 772,760 500,000

Entries for interest income is based on the table

When the lease expires on 12/31/2023, the machinery will revert back to the lessor.

Whether guaranteed or unguaranteed, the entry on the books of the lessor will be the same.
Machinery 500,000
Lease receivable 500,000

If 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 for the difference.

Cash 100,000
Machinery 400,000
Lease receivable 500,000

Under the unguaranteed scenario, the lessor shall recognize a loss for the difference.

Loss on finance lease 100,000

Machinery 400,000
Lease receivable 500,000

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Direct Financing lease –transfer of title to lessee

Jan., 1, 2020, Lessor leased a machinery to another entity with the following details
Cost of machinery 3,449,600
Residual value 500,000
Useful life and lease term 5 years
Implicit rate of interest 8%

The annual rental is payable in advance on January 1 of each year starting Jan. 1, 2020.

The lease provides for a transfer of title to the lessee at the end of the lease term.

PV of an annuity of 1 in advance at 8% for 5 periods 4.312

Determine the annual rental:

Cost f machinery to be recovered from rental 3,449,600
Divide by PV of an annuity of 1 in advance
at 8% for 5 periods 4.312
Annual rental 800,000

 If the machinery will not revert back to the lessor, the residual value is completely ignore in
the computation of annual rental, hence:

Gross rentals (P800,000 x 5 years) 4,000,000

Net investment 3,449,600
Unearned interest income 550,400

TABLE OF AMORTIZATION
Date Payment 8% Interest Principal Present value
1/1/20 3,449,600
1/1/20 800,000 - 800,000 2,649,600
1/1/21 800,000 211,968 588,032 2,061,568
1/1/22 800,000 164,925 635,075 1,426,493
1/1/23 800,000 114,119 685,881 740,612
1/1/24 800,000 59,388 740,612 -

Entries for interest income is based on the table

Entries:
1/1/2020 Lease receivable 4,000,000
Machinery 3,449,600
Unearned interest income 550,400