Accounting for Direct Financing Leases
Under ASC 842, a direct financing lease is a lease (from the lessor’s perspective) where the lessor effectively acts as a financier rather than a manufacturer or dealer. In a direct financing lease, the lessor transfers substantially all the risks and rewards of the asset to the lessee, but does not recognize any selling profit immediately.
Instead, any selling profit (fair value minus carrying value) is deferred through recognizing higher interest income on the net investment in the lease over the lease term. This is in contrast to a sales-type lease, where selling profit is recognized at lease commencement.
1. Determine the Value of the Lease Receivable
Definition: Lease Receivable
A lessor’s right to receive lease payments arising from a sales-type lease or a direct financing lease plus any amount that a lessor expects to derive from the underlying asset following the end of the lease term to the extent that it is guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis.
It is important to first determine the value of the lease receivable, as this could impact the lease classification below.
In measuring the lease receivable, the lessor uses the rate implicit in the lease.
Rate implicit in the lease: the rate of interest that, at a given date, causes the aggregate present value of
- the lease payments and
- the amount that a lessor expects to derive from the underlying asset following the end of the lease term
to equal the sum of
- the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and
- any deferred initial direct costs of the lessor.
The lease receivable will therefore equal the fair value of the asset and initial direct costs.
2. Determine Lease Classification
Under ASC 842, lessors follow a two-step classification: first determine if it’s a sales-type lease, and then whether it qualifies as a direct financing lease.
A lease is a sales-type lease if any of the five criteria in 842-10-25-2 are met:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
If none of those criteria are met, the lessor applies additional tests. Specifically, the lessor classifies a lease as a direct financing lease only when both of these conditions are met:
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.
- Collectibility is probable: It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.
If these two conditions are met and none of the sales-type criteria apply, the lease is a direct financing lease. Otherwise, the lease would be an operating lease for the lessor.
Key insight
Note how 842-10-25-2 (d) does not include third party guarantees for sales-type lease classification, making third party guarantees a common theme among direct financing leases. The guarantee must however, be large enough to satisfy the above requirement. Leases with third-party guarantees can however still be sales-type leases - therefore it's important to consider the steps outlined above carefully.
3. Recognition of Direct Financing Leases
At the lease commencement date (when the underlying asset is made available), a direct financing lease is accounted for as follows:
-
Derecognize the asset: The lessor removes the leased asset from its books. In exchange, the lessor recognizes the net investment in the lease, which represents its receivable from the lease.
-
Record net investment: The net investment is initially measured at the present value of the lease receivable and any unguaranteed residual value, discounted at the implicit rate. Because selling profit is deferred, the initial net investment typically equals the carrying amount of the asset (plus any deferred costs). For example, if the asset’s carrying value is $100,000 and there’s no profit or loss, the net investment will also be $100,000.
-
Selling profit or loss: Any selling profit (fair value above carrying) is not recognized immediately in income; it is credited to the net investment. Any selling loss (carrying value above fair value) is however recognized immediately in profit or loss.
-
Initial direct costs: Any initial direct costs incurred by the lessor are deferred and included in the net investment, regardless of whether the asset’s fair value equals its carrying amount. (The implicit rate is defined so that deferred costs are automatically part of the investment.)
Journal entry (example):
Dr Net Investment in Lease XXX
Cr Underlying Asset (PPE) XXX
(If a loss, an additional debit to loss would be recorded; if no profit/loss, no income is recognized.)
4. Measuring the Net Investment In The Lease
Definition: Net Investment In The Lease
For a direct financing lease: the sum of the lease receivable and the unguaranteed residual asset, net of any deferred selling profit.
The net investment in the lease in a direct financing lease therefore consists of three components:
- Lease receivable: The present value of future lease payments and residual value guarantees, discounted at the rate implicit in the lease.
- Unguaranteed residual asset: The present value of any estimated residual value of the asset not guaranteed by the lessee or third parties.
- Less: Deferred selling profit (not loss)
The effect of deducting the selling profit from the net investment in the lease’s balance, is that the net investment in the lease is measured at the carrying amount of the underlying asset, rather than its fair value (as in a sales-type lease).
5. Subsequent Measurement
Entities with direct financing lease cannot use the rate implicit in the lease as defined to determine interest income, as the rate would be lower than the effective yield of the net investment in the lease. With a lower net investment in the lease, the discount rate needs to be higher to arrive at the same future value at the end of the lease.
Instead, the lessor calculates a new effective interest rate, following the definition of the rate implicit in the lease, but using the carrying amount of the asset as opposed to its fair value. For more details on this, please see 842-30-35-1.
After initial recognition, the lessor accounts for the direct financing lease as follows:
-
Interest income: The net investment is accreted over time. The lessor recognizes interest income on the net investment each period, using the effective interest rate as mentioned above.
-
Lease payments:
Dr Cash (Lease Payment) XXX
Cr Interest Income YYY
Cr Net Investment (Principal) ZZZ
Interest (YYY) = previous net investment × effective rate;
Principal (ZZZ) = payment – interest.
-
No remeasurement: The net investment is not remeasured each period; it simply accretes interest and is reduced by payments.
-
Variable payments: Any variable lease payments not included in the net investment are recognized in profit or loss in the period incurred.
-
Impairment: The net investment is subject to impairment testing like a financial asset under ASC 326.
6. Derecognition (Lease Termination)
If a direct financing lease is terminated early:
- Test for loss. First, test the net investment for impairment (credit losses) under ASC 326. Recognize any loss immediately.
- Reclassify the remaining net investment. The remaining net investment (lease receivable plus residual) is reclassified to appropriate asset accounts (for example, a receivable or the underlying asset) at its carrying amount.
- Account for the underlying asset under PPE rules at carrying value. The underlying asset returned by the lessee is then recognized on the lessor’s books under PPE rules at its carrying value. Essentially the lease is unwound and the asset is treated as if reacquired (subject to cost and any impairment adjustments).
Practical Example - Direct Financing Lease
Scenario
A lessor leases equipment for 6 years with annual payments of 9,500, payable in arrears. There is an expected residual value of 20,000 at the end of the lease term, of which 13,000 is guaranteed by a third party (not the lessee).
Other facts:
- Carrying amount (cost) of equipment: 54,000
- Fair value of equipment: 62,000
- Initial direct costs: 2,000
- Collectibility is probable
The present value of lease payments plus the third-party guaranteed residual equals substantially all of the asset’s fair value. Note that when this third-party guarantee is excluded, the requirement is not met, which is why it does not qualify as a sales-type lease under 842-10-25-2(d).
Conclusion: the lease is classified as a direct financing lease.
Accounting Implications at Commencement
- No selling profit is recognised, even though fair value (62,000) exceeds cost (54,000).
- The net investment in the lease (NIL) is measured as:
NIL = Carrying amount + Initial direct costs
= 54,000 + 2,000
= 56,000
- The underlying asset is derecognised.
- Initial direct costs are capitalised into the NIL.
- The “embedded” profit of 8,000 (62,000 – 54,000) is deferred and not recognised in profit or loss.
The NIL is conceptually made up of:
- Lease receivable – present value of lease payments plus third-party residual guarantee
- Unguaranteed residual asset – present value of the portion of the residual not guaranteed
- Less: deferred selling profit
Subsequent Accounting
- A higher effective interest rate is used so that the NIL amortises from 56,000 to the residual value of 20,000 over the lease term.
- The rate implicit in the lease (based on fair value) would be 4.65% (N=6, PMT=9,500, PV=-62,000+2,000, FV=20,000).
- The effective interest rate, based on the NIL, would be 8.26% (N=6, PMT=9,500, PV=-54,000+2,000, FV=20,000).
- Interest income is recognised on the NIL each period.
- Part of the interest effectively represents the gradual release of the deferred selling profit.
Result: profit emerges over time rather than upfront.
End of Lease
- At the end of the lease, the NIL equals the expected residual value of 20,000.
- It is reclassified back to equipment on the balance sheet.
Conclusion
Direct financing leases under ASC 842 allow a lessor to earn interest income on a leased asset without immediately recognizing sales revenue. The lessor derecognizes the asset and records a net investment receivable, deferring any profit through higher finance income in later periods.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.