CHAPTER 13: DIRECT FINANCING LEASE – LESSOR 12/31/2023 500,000 101,399 398,601 446,394

12/31/2024 500,000 53,567 446,433 -

Dec. 31
DIRECT FINANCING LEASE – Recognizes only interest income.
2021
 The lessor is actually engaged in the financing business.
 Arrangement between a financing entity and a lessee. Unearned interest income 182,238
 The income of the lessor is only in the form of interest income.
 No dealer profit is recognized because of the fair value and Interest income 182,238
the cost of the asset are equal.
2022
SALES TYPE LEASE – Recognizes interest income and gross profit.
Unearned interest income 144,107
ACCOUNTING CONSIDERATIONS
Interest income 144,107
a. Gross Investment in the lease is equal to the gross rentals
for the entire lease term plus the absolute amount of the Direct financing lease – with IDC
residual value, whether guaranteed or unguaranteed.
On January 1, 2021, Lessor Company leased a machinery to another
b. Net Investments in the lease is equal to the cost of the asset
entity with the following information:
plus any initial direct cost paid by the lessor.
c. Unearned Interest Income is the difference between the Cost of machinery 1,518,650
gross investment and the net investment in the lease.
d. Initial Direct Cost paid by the lessor is added to the cost of Annual rental payable 500,000
the asset to get the net investment in a direct financing lease.
Lease term 4 years
 The IDC would effectively spread the IDC over the lease
term and reduce the amount of interest income. Useful life 4 years
 PV = net investment or cost of machinery
 EIM is used in recognizing interest income. Implicit interest rate before IDC 12%
 Lessor shall recognize finance income over the lease
term based on a pattern reflect a constant periodic rate PV of annuity of 1 3.0373
of return on the lessor’s net investments in the lease.
On January 1, 2021, Lessor Company paid initial direct cost of P66,300.
Illustration – Direct Financing Lease
 The Initial direct cost is added to the cost of the
On January 1, 2021, Lessor Company lease a machinery to another machinery to determine the net investment in the lease.
entity with the following information:  IDC would decrease implicit interest rate.

Cost of machinery 1,518,650 Cost of machinery 1,518,650

Annual rental payable 500,000 Initial direct cost 66,300

Lease term 4 years Net investment in the lease 1,584,950

Useful life of machinery 4 years Gross rentals 2,000,000

Implicit interest rate 12% Net investment in the lease (1,584,950)

PV of annuity of 1 3.0373 Unearned interest income 415,050

*Annual rental (if not given) = net investment/pv of annuity of 1  The original implicit interest rate cannot be applied
because of the added IDC.
Gross rentals/lease receivable (500,000 x 4yrs) 2,000,000  Use T-A-E method to determine the new IIR

PV of gross rentals (1,518,650) New PV of annuity of 1 for 4 periods at 10% 3.1699

Unearned interest income 481,350 Journal Entries

Journal Entries Machineries (IDC) 66,300

Lease receivable 2,000,000 Cash 66,300

Machinery 1,518,650 Lease receivable 2,000,000

Unearned interest income 481,350 Machinery 1,584,950

Annual collection of rental Unearned interest income 415,050

Cash 500,000 Annual collection of rental

Lease receivable 500,000 Cash 500,000

DATE PAYMENT INTEREST PRINCIPAL PV Lease receivable 500,000

1/1/2021 1,518,650 DATE PAYMENT INTEREST PRINCIPAL PV
12/31/2021 500,000 182,238 317,762 1,200,888 1/1/2021 1,584,950
12/31/2022 500,000 144,107 355,893 844,995 12/31/2021 500,000 158,495 341,505 1,243,445
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 12/31/2022 500,000 124,345 375,656 867,790 Net investment to be recovered 2,852,910
12/31/2023 500,000 86,779 413,221 454,568
Annual rental = 2,852,910/3.1699 = 900,000
12/31/2024 500,000 45,432 454,568 -
 The PV of residual value is deducted from the cost of the
asset if the machinery will revert to the lessor at the end
Journal Entries of lease term.
Dec. 31  Otherwise, the residual value is ignored.

2021 Gross rentals (900,000 x 4years) 3,600,000

Unearned interest income 158,495 Residual value (whether guaranteed or not) 500,000

Interest income 158,495 Gross investment 4,100,000

2022 Cost of machinery – Net investment (3,194,410)

Unearned interest income 124,345 Unearned interest income 905,590

Interest income 124,345 DATE PAYMENT INTEREST PRINCIPAL PV

 If the BS is prepared by the lessor on December 31, 1/1/2021 3,194,410

2021, the lease receivable of P1,500,000 would be 12/31/2021 900,000 319,441 580,559 2,613,851
reported as partly current and partly noncurrent. 12/31/2022 900,000 261,385 638,615 1,975,236
Current portion 12/31/2023 900,000 197,524 702,476 1,272,760
12/31/2024 900,000 127,240 772,760 500,000
Lease receivable 500,000
Journal Entries
Unearned interest income (124,345)
2021
Carrying amount 375,655
1. To record direct financing lease
Noncurrent portion
Lease receivable 4,100,000
Lease receivable 1,000,000
Machinery 3,194,410
*Unearned interest income (132,211)
Unearned interest income 905,590
Carrying amount 867,789
2. To record the collection of annual rental
*unearned interest income 415,050
Cash 900,000
Realized in 2021 (158,495)
Lease receivable 900,000
Balance – 12/31/21 256,555
3. To record interest income
Realizable in 2022 (124,345)

Realizable beyond 2022 132,210 Unearned interest income 319,441

Interest income 319,441

When the lease expires on December 31, 2024, the machinery will revert
Direct financing lease – with RESIDUAL VALUE
to the lessor.
On January 1, 2021, Lessor Company leased a machinery to another
Machinery 500,000
entity with the following details:
Lease receivable 500,000
Cost of machinery 3,194,410

Residual value 500,000

Accounting problem
Useful life and lease term 4 years
When the fair value of machinery is 400,000 which is lower than the
Implicit interest rate 10%
residual value of 500,000
The machinery shall revert to the lessor at the end of the lease term
Guaranteed scenario
because there is neither a transfer of title nor a purchase option.
Cash 100,000
PV of 1 = 1.1-4 = 0.683
Machinery 400,000
PV of O.A of 1 = 1-(1.1-4)0.1 = 3.1699
Lease receivable 500,000
Cost of machinery 3,194,410
Unguaranteed scenario
PV of residual (500,000 x .683) (341,500)
Loss on finance lease 100,000
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Machinery 400,000 2022

Lease receivable 500,000 Jan 1

Illustration Cash 1,000,000

On January 1, 2021, Lessor Company leased a machinery to another Lease receivable 1,000,000
entity with the following details:
Dec 31
Cost of machinery 3,760,100
Unearned interest income 203,611
Residual value – guaranteed 400,000
Interest income 203,611
Useful life and lease term 4 years
2023
Implicit interest rate 10%
Jan 1
The annual rental is payable in advance on January 1 of each year
starting on January 1, 2021. Cash 1,000,000

PV of 1 = 1.1-4 = 0.683 Lease receivable 1,000,000

PV of annuity in advance = [1-(1.1-3)/1] + 1 = 3.4869 Dec 31

Cost of machinery 3,760,100 Unearned interest income 123,972

PV of residual value (400,000 x 0.683) (273,200) Interest income 123,972

Net investment to be recovered 3,486,900 2024

Annual rental = 3,486,900/3.4869 = 1,000,000 Jan 1

Gross rentals (1,000,000 x 4years) 4,000,000 Cash 1,000,000

Residual value – guaranteed 400,000 Lease receivable 1,000,000

Gross investment 4,400,000 Dec 31

Net investment – cost of machinery (3,760,100) Unearned interest income 36,307

Unearned interest income 639,900 Interest income 36,307

DATE PAYMENT INTEREST PRINCIPAL PV 2025

1/1/2021 3,760,100 Jan 1
1/1/2021 1,000,000 1,000,000 2,760,100
1/1//2022 1,000,000 276,010 723,990 2,036,110 The fair value of the machinery is 300,000 only. The lessee shall pay the
1/1/2023 1,000,000 203,611 796,389 1,239,721 difference to the lessor.
1/1/2024 1,000,000 123,972 876,028 363,693 Cash 100,000
1/1/2025 400,000 36,307 363,693 -
Journal Entries Machinery 300,000

2021 Lease receivable 400,000

Jan 1

Lease receivable 4,400,000 Direct financing lease – TRANSFER OF TITLE TO LESSEE

Machinery 3,760,100 On January 1, 2021, Lessor Company leased a machinery to another

entity with the following data:
Unearned interest income 639,900
Cost of machinery 3,449,600
Cash 1,000,000
Residual value 500,000
Lease receivable 1,000,000
Useful life and lease term 5 years
Dec 31
Implicit interest rate 8%
Unearned interest income 276,010
The annual rental is payable in advance on January 1 of each year
Interest income 276,010 starting January 1, 2021.

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

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PV of O.A of 1 in advance = [1-(1.08-4)/1] +1 = 4.312 At the end of the lease term, the equipment shall revert to the lessor.

 If the machinery will not revert to the lessor at the end of At the beginning of current year, an equipment is leased to a lessee with
the lease term because the lease provides for a transfer the following information:
of title to the lessee, the residual value is ignored.
Cost of equipment to the lessor 5,000,000
Annual rental = 3,449,600/4.312 = 800,000
Residual value – unguaranteed 600,000
Gross rentals (800,000 x 5years) 4,000,000
Annual rental payable at the beginning 900,000
Net investment – cost of machinery (3,449,600)
Initial direct cost 250,000
Unearned interest income 550,400
Useful life and lease term 8 years
DATE PAYMENT INTEREST PRINCIPAL PV
Implicit interest rate after considering IDC 12%
1/1/2021 3,449,600
1/1/2021 800,000 800,000 2,649,600 1. Gross investment = 900,000 x 8 = 7,200,000 + 600,000 =
7,800,000
1/1/2022 800,000 211,968 588,032 2,061,568
2. Net investment = 5,000,000 + 250,000 = 5,250,000
1/1/2023 800,000 164,925 635,075 1,426,493 3. Total interest income = 7,800,000 – 5,250,000 = 2,550,000
1/1/2024 800,000 114,119 685,881 740,613 4. Interest income – 2021 = 5,250,000 – 900,000 = 4,350,000
x 12% = 522,000
1/1/2025 800,000 59,387 740,613 -
13-5
Journal Entries Oceanic Company is engaged in leasing equipment. Such an equipment
was delivered to a lessee at the beginning of current year under a direct
2021 financing lease with the following provisions:
Jan 1 Cost of equipment 4,361,200
Lease receivable 4,000,000 Unguaranteed residual value 200,000
Machinery 3,449,600 Useful life and lease term 8 years
Unearned interest income 550,400 Implicit interest rate 10%
Cash 800,000 PV of O.A of 1 5.335
Lease receivable 800,000 PV of 1 0.466
Dec 31 The annual rental is payable at the end of each year. The equipment
shall revert to the lessor upon the lease expiration.
Unearned interest income 211,968
1. Net investment to be recovered = 4,361,200 – 93,200 =
Interest income 211,968
4,268,000
2022 200,000 x .466 = 93,200
2. Annual rental = 4,268,000/5.335 = 800,000
Jan 1 3. Interest income – 2021 = 4,361,200 x 10% = 436,120

Cash 800,000 13-6

Lease receivable 800,000 At the beginning of current year, Lessor Company leased a machine to
Lessee Company. The machine had an original cost of P6,000,000. The
lease term was five years and the implicit interest rate on the lease was
15%.
Dec 31
The lease is properly classified as direct finance lease. The annual lease
Unearned interest income 164,925 payments of P1,750,000 are made each December 31.
Interest income 164,925 The machine reverts to Lessor at the end of each term, at which time
the residual value of the machine will be P275,000. The residual value
is unguaranteed.
Problems
1. Net lease receivable on the part of the lessor = 6,000,000
13-4 Lease receivable = cost of asset
2. Gross investment = 1,750,000 x 5 years = 8,750,000 +
Camia Company is in the business of leasing new sophisticated 275,000 = 9,025,000
equipment. The lessor expects 12% return on net investment after 3. Total unearned interest income = 9,025,000 – 6,000,000 =
considering the initial direct cost. 3,025,000
4. Interest income – 2021 = 6,000,000 x 15% = 900,000
All leases are classified as direct financial lease.

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13-7
At the beginning of current year, Lyle Company entered into a 5-year
direct financing lease. A third party guaranteed the residual value of the
asset under the lease estimated to be P1,200,000 at the end of lease
term.
Annual lease payments of P1,000,000 are due at the end of each lease
year.
The remaining useful life of the asset was 6 years at the commencement
of the lease.
The lessor used 10% as the implicit interest rate. The PV of 1 is 0.62,
and the PV of O.A of 1 is 3.79.
1. Net lease receivable = 3,790,000 + 744,000 = 4,534,000
1,000,000 x 3.79 = 3,790,000
1,200,000 x .62 = 744,000
2. Gross investment = 1,000,000 x 5 = 5,000,000 +1,200,000
= 6,200,000
3. Total unearned interest income = 6,200,000 – 4,534,000 =
1,666,000
4. Interest income – 2021 = 4,534,000 x 10% = 453,400
13-9
Glade Company leases a computer equipment under a direct financing
lease. The equipment has no residual value at the end of the lease and
the lease does not contain purchase option.
The entity wishes to earn 8% interest on 5-year lease of equipment with
a cost of P3,234,000
The PV of annuity due (advance) is 4.312.
Total interest revenue = 3,234,000/4.312 = 750,000 x 5 years =
3,750,000 – 3,234,000 = 516,000
13-11
Cassandra Company is in leasing business. The entity acquired a
specialized packaging machine for P3,000,000 cash and leased it for a
period of six years, after which the machine is to be returned to
Cassandra Company for disposition. The guaranteed residual value of
the machine is P200,000.
The lease term was arranged so that a return of 12% is earned by
Cassandra Company.
The PV of 1 is 0.51 and the PV of annuity due is 4.6.
Annual lease rental = 3,000,000 – 102,000 = 2,898,000/4.6 = 630,000
200,000 x .51 = 102,000
13-12
Magnum Company had an asset costing P5,239,000. The asset was
leased at the beginning of current year to another entity. Five annual
lease payments are due in advance at the beginning of each lease year.
The lessee guaranteed the P2,000,000 residual value of the asset at the
end of the 5-year lease term.
The lessor’s implicit interest rate is 8%. The PV of 1 is 0.68, and the PV
of annuity due is 4.31.
Annual lease payment = 5,239,000 – 1,360,000 = 3,879,000/4.31 =
900,000
2,000,000 x .68 = 1,360,000
13-13
Ericson Company leased an asset to another entity. The cost of the
asset was P7,994,000. Terms of the lease specified four year-end rental
payments. The lease qualified as a direct financing lease.
The lease provided for a transfer of title to the lessee at the end of the
lease term.
After the fourth year, the residual value was estimated at P1,000,000.
The PV of 1 is 0.572, and the PV of O.A of 1 is 2.855.
Annual rental payment = 7,994,000/2.855 = 2,800,000
 Ignored yung residual kasi may transfer of title.
13-14
Irene Company acquired a specialized machine for P2.300,000. At the
beginning of current year, the entity leased the machine for a period of
six years, after which title to the machine is transferred to the lessee.
The six annual lease payments are due in advance at the beginning of
each lease year. The residual value of the machine is P200,000.
The lease terms are arranged so that a return of 12% is earned by the
lessor. The PV of 1 is 0.51, and the PV of annuity due is 4.6.
Annual lease rental = 2,300,000/4.6 = 500,000
Theories
1. Gross investment in the lease is equals to
 Sum of the lease payments receivable by a lessor under
a finance lease and any unguaranteed residual value
accruing to the lessor.
2. Net investment a direct financing lease is equal to
 Cost of asset plus initial direct cost paid by lessor.
3. Which is the correct accounting treatment for a finance lease
in the accounts of lessor?
 Receivable equal to net investment in the lease and
recognize finance payments by reduction of debt and
taking interest to income statement.
4. Lessor shall recognize asset held under a finance lease as a
receivable at an amount equal to the
 Net investment in the lease.
5. The lease receivable in a direct financing lease is
 The PV of lease payments.
6. The primary difference between a direct financing lease and
a sales type lease is the
 Recognition of dealer profit at inception of the lease.
7. All of the following would be included in the lease receivable:
 Guaranteed/Unguaranteed residual value.
 A purchase option that is reasonably certain.
8. Under a direct financing lease, the excess of aggregate
rentals over the cost of the underlying asset should be
recognized as interest income of the lessor.
 In decreasing amounts during the term of the lease.
9. In a direct financing lease, unearned interest income should
be
 Amortized over the lease term using the interest method.
10. All of these are true regarding IDC incurred by the lessor
 In a direct financing lease, IDC shall be added to the net
investment in the lease.
 In a sales type lease, IDC shall be expensed as
component of COGS.
 In an operating lease, IDC shall be deferred and
allocated over the lease term.
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