CHAPTER 13

DIRECT
FINANCING
LEASE-LESSOR
 TECHNICAL
KNOWLEDGE
To know the finance lease classification on the part
of lessor.
To define a direct financing lease.
To distinguished a direct financing lease from a sales
type lease.
To understand gross investment and net investment
in a direct financing lease.
To recognize interest income in a direct financing
lease using the effective interest method.
What is Lease?

A Lease is contract whereby the owner of an asset grants the other party
the exclusive right to use the asset for an agreed period of time in return for
payment of rent.

A Lease agreement is a legal contract used when a party conveys land or

personal property to another party for a specific amount of time in return
for payment.

The lease agreement outlines all of the aspects of the lease arrangement so
that each party understands his rights and obligations under lease.

Formal lease agreements are legally binding on both parties, and breach of
the agreement, or failure to uphold the provisions of the agreement, has
legal consequences.
Example of Lease

Suppose Fahim leases a house from Sithil, he signs a lease agreement that specifies the location of the home, the
monthly payment amount, the duration of the lease, and any other requirements of the parties, such as a ban on
pets.

The lease is legally binding, so if Fahim moves out early, he may be held liable to pay for the entire length of the
lease, even though he was no longer living there.
 LEASE FINANCING

Lease financing is one of the important sources of medium and long

term financing where the owner of an asset gives another person, the right
to use the asset periodical payments.

The owner of the asset is known as lessor

The user is called lessee.
The periodical payment made by tthe lessee to the lessor is known as
lease capital.
Under lease financing, lessee is given the right to use the asset but the
ownership lies with the lessor and at the end of lease contract, the
asset is returned to the lessor or an option is given to the lessee either
to purchase the asset or to renew the lease agreement
FINANCE LEASE CLASSIFICATION

Direct Financing Lease

Sales Type Lease

Direct financing Lease

is a financing arrangement in which the lessor acquires assets and

leases them to its customers, with the intent of generating revenue
from the resulting interest payments. A direct financing lease is
usually offered by financing institutions, such as equipment leasing
companies.
Direct financing Lease

Is engaged in the financing business

Is an arrangement between a fianncing entity and a lessee
Is the result of an entity’s need to finance the acquisition of an asset
No dealer profit is recognized because the fair value & the cost of
the asset are equal
Accounting Considerations

Gross Investment in the lease

is equal to the gross rentals for the
entire lease term plus absolute amount Net investment in the lease
of the residual value, whether
guaranteed or unguaranteed. is equal to the cost of the asset plus any
initial direct cost paid by the lessor.
Accounting Considerations

Unearned interest income

is the difference between the gross
investment and net investment in the Initial direct cost paid by the
lease.
lessor
is added to the cost of the asset to get the
net investment in a direct financing lease.
 Illustration – Direct Financing Lease
On January 1, 2022, Lessor Company leased a machinery to another entity with the following details:
Table of Amortization

Recognition of interest income

Effective interest method
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.
Direct Financing Lease- With Initial Direct Cost
On January 1,2022,Lessor Company leased a machinery to The inclusion of the initial direct cost in the net investment in
another entity with the following details: lease will have the effect of spreading the initial direct cost over
the lease term and reduce the interest income from the finance
Cost of machinery 1,518,650 lease.
Annual rental payable at the end of each 500,000
Lease term year 4 years Gross rentals 2,000,000
Useful life of machinery 4 years Net investmentin the lease 1,584,950
Implicit interest rate before initial direct cost 12% Unearned interest income 415,050
Present value of annuity of 1 for 4 years a 12% 3.0373
Consequently, the initial direct cost would decrease inplicit
On January 1,2022,Lessor Company paid initial direct cost of P66,300. interest rate in the lease.

The initial direct cost is added to the cost of the machinery to The problem therefore is the determination of the reduced
determine the net investment in the lease. implicit interest rate.

Cost of machinery 1,518,650 The original implicit interest rate of 12% cannot be applied
Initial direct cost 66,300 anymore because of the added initial direct cost.
Net investment in the lease 1,584,950

12%- original implicit rate

11%- (PV of an ordinary of 1 at 11% for 4 years)= 3.1.04

500,000 x 3.1024= 1,551,200

Computation of New Implicit Rate
Using 10%
(PV of an ordinary of 1 at 10% for 4 years)- 3.1699
500,000 x 3.1699= 1,584,950

Recorded as follow:

Machinery (initial direct cost) 66,300

Table of Amortization
cash 66,300

Lease receivable 2,000,000

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

The annual collection is normally recorded:

Cash 500,000
Lease receivable 500,000
Statement of Financial Position
IFRS 16, paragraph 67, states that lessors shall recognize assets held under a finance
lease as a receivable at an amount equal to the net investment in the lease.
Direct Financing Lease - with Residual Value
On January 1,2022,Lessor Company leased a machinery to another entity
with the following details:

Cost of machinery 3,194,410

Residual value 500,000 Note that the present value of the residual value is deducted from the
Useful life and lease term 4 years cost of the asset if the machinery shall revert to the lessor at the end of
Implicit interest rate 10% the lease term.

The machinery shall revert to the lessor at the end of the lease term Otherwise,if the machinery shall not revert to the lessor at the end of
because there is neither a transfer of title nor a purchase option. the lease term,the residual value is completely ignored.

The problem is the determination of the annual rental. The annual rental Gross rentals (900,000x4) 3,600,000
is payable at the end of each year with the first payment on December
Residual value(whether guaranteed or unguaranteed) 500,000
31,[Link] relevant present value factors are:
Gross investment 4,100,000
PV of 1 at 10% for 4 periods .6830 Cost of machinery-net investment (3,194,410)
PV of an ordinary annuity of l at 10% for 4 periods 3.1699 Unearned interest income 905,590

Cost of machinery 3,194,410

Present value of residual value (500,000x.683) (341,500)
Net investment to be recovered from rental 2,852,910
Divide by PV of an ordinary annuity of 1 at 10% for 4 periods 3.1699
Annual rental 900,000
Table of Amortization
Direct Financing Lease - rental payable in advance
On January 1,2022, Lessor Company leased a machinery to another
entity with the following details:

Cost of machinery 3,760,100

Residual value guarantee 400,000 Computation of annual rental
Useful life and lease term 4 years
Implicit interest rate 10% Cost of machinery 3,760,100
Present value of residual value(400,000x.683) (273,200)
The annual rental is payable in advance on January 1 of each year Net investment to be recovered from rental 3,486,900
starting January 1,2022. Divide by PV of annuity of 1in advance at 10% for 4 periods 3.4869
Annual rental 1,000,000
Since the residual value is guaranteed, the machinery shall revert to the
lessor at the end of the lease term.
Note that the rental is payable in advance at the beginning of each
[Link],the "annuity of 1 in advance factor" is used in the computation.
The relevant present value factors are:

Present value of 1 at 10% for 4 periods 0.6830 Gross rentals (1,000,000x4 years) 4,000,000
Present value of an annuity of 1 in advance at 10% for 4 periods 3.4869 Residual value-guaranteed 400,000

Gross investment 4,400,000

Net investment-cost of machinery 3,760,100
Unearned interest income 639,900
Table of Amortization
Direct Financing Lease - transfer of title to lessee
On January 1,2022,Lessor Company 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 If the machinery shall not reuert to tre- lessor at the end of the
Implicit interest rate 8% lease term because the lease provides for a transfer of title to the
lessee, the residual value is completely ignored in the computation
The annual rental is payable in advance on January 1 of each year starting of the annual rental and the unearned interest income.
January 1,2022.
The annual rental is payable in advance. Thus, the annuity of 1 in
The lease provided for a transfer of title ta the·lessee at the end of the lease advance or annuity due factor is used in the computation.
term.
Gross rentals (800,000x 5 years) 4,000,000
The present value of an annuity of 1in advance at 8% for 5 periods is 4.312. Net investment-cost of machinery 3,449,600
Unearned interest income 550,400
Cost of machinery to be recovered from rental 3,449,600
Divide by PV of an annuity of 1in advance at 8% for 5 periods 4.312
Annual rental 800,000
Table of Amortization
THANK YOU