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Direct Financing Lease Journal Entries – ASC 842 Lessor

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In this article, we’ll provide a clear and straightforward guide to the journal entries a lessor should make under the direct financing Lease, as outlined by ASC 842. 

Related reading:

ASC 842 Journal Entries – Sales-type Lease (Lessor)

ASC 842 Journal Entries – Operating Lease (Lessee and Lessor)

ASC 842 Journal Entries – Finance Lease (Lessee)

Month-To-Month Lease Under ASC 842

Basics of Direct Financing Lease

Definition

A direct financing lease is a specific leasing arrangement in which the lessor’s primary role is that of a financier who derives income from interest. At the end of the term, the asset is typically returned to the lessor since the lessee isn’t granted an option to purchase or assume ownership.

Criteria for Classification as a Direct Financing Lease

In order to classify a lease as a direct financing lease, there are two steps to verify.

Step 1: Every single criterion below is met. If any of them is not met, then it’s a sales-type lease for the lessor.

  1. The underlying asset will not be transferred to the lessee by the end of the lease term.
  2. The lessee isn’t granted an option to purchase the asset that they are reasonably certain to exercise.
  3. The lease term doesn’t represent a major part of the asset’s economic life (i.e., less than 75%).
  4. The present value of the sum of lease payments and residual value guaranteed by the lessee doesn’t constitute substantially all of the fair value of the underlying asset. (i.e., less than 90%)
  5. The underlying asset is not specialized or customized. In other words, it can be used by any other parties without issues.

If the lease passes step 1, it must undergo another test to be classified as a direct financing lease.

Step 2: Both of the criteria below are met. If any of them is not met, then it’s an operating lease for the lessor.

  1. It’s probable the lessor will receive all the expected lease payments and any additional amounts tied to a residual value guarantee.
  2. The present value of the sum of the lease payments and any residual value guaranteed by the lessee, plus any third party such as an insurance company, constitutes substantially all of the fair value of the underlying asset.
    • Notes on third-party guarantee: the criterion in step 1 is for residual value guaranteed by the lessee only. For instance, if the PV of payment and residual value guaranteed by the lessee is only 80% of the FV, it won’t be classified as a sales-type lease based on step 1. But if the remaining 20% is guaranteed by an insurance company (third party), it will pass step 2 and be classified as a direct financing lease. What if there is no guarantee from another third party? Then, it will fail this criterion as well and be classified as an operating lease.

If the lease passes both step 1 and step 2 classification tests, it will be classified as a direct financing lease. If the lease fails the step 1 test, it’s a sales-type lease. If the lease fails the step 2 test, it’s an operating lease. Keep in mind this test is purely for the lessor. For lessees, they are classified either as operating or financing.

Financial Statement Impact

  • The leased asset is derecognized or removed from the lessor’s balance sheet.
  • The lessor recognizes a Net Investment in the Lease, which is an asset (think of it as “lease receivable”). It represents the present value of future lease payments plus any guaranteed & unguaranteed residual value, minus any profit or loss that would have been recognized in a sale.
  • Over the lease term, interest revenue is recorded based on the implicit rate in the lease, representing the lessor’s return on the net investment.

Difference between a Direct Financing Lease and a Sales-type Lease for Lessors

A sales-type lease recognizes a selling profit/loss up front, while a direct financing lease does not record the profit/loss at the beginning of the lease. Instead, it delays the profit into the future periods where the interest income is recognized.

Difference between a Direct Financing Lease and an Operating Lease for Lessors

In an operating lease, lessors keep the asset on their books and recognize depreciation, booking lease income as they collect payments. In contrast, in a direct financing lease, the asset is removed, and a Net Investment in the Lease is recognized, with income derived from interest.

Related reading:

What Is a Lease Accountant and What Do They Do?

Journal Entries Example – Direct Financing Lease

Scenario

The Oven Lease Company (Lessor) leased oven equipment to the Pho My Life Noodle Shop (Lessee). The terms are as follows:

  • Term: 3 years
  • Payment: $2,847 annually
  • Interest rate: 5%
  • Residual value: $2,000
  • Cost of the equipment: $8,000

Before recording journal entries, two calculations are necessary: Net Investment in the Lease and the implied interest rate.

Calculation of Net Investment in the Lease

Here is the formula to calculate the Net Investment in the Lease balance in a direct financing lease:

Net Investment in the Lease = PV of lease payment + PV of guaranteed and unguaranteed residual value of the asset – any profit

PV of lease payment: Using a calculator, the PV comes out to be $7,753.

PV Calculator Scenario payment

PV of guaranteed and unguaranteed residual value of the asset: Using a calculator, the PV comes out to be $1,728.

PV Calculator Scenario Residual Value

Profit: Profit is the PV of lease payment and the residual value of the asset, minus the carrying cost. $7,753 (PV of payment) + $1,728 (PV of asset’s residual value) – $8,000 (Carrying value) = $1,481

As a result, Net Investment in the Lease = $7,753 (PV of lease payment) + $1,728 (PV of asset’s residual value) – $1,481 (profit) = $8,000.

In a direct financing lease, no profit & loss is recognized upfront unlike the sales-type lease. Therefore, it makes sense that the Net Investment in the Lease balance is the same as the carrying value in this simplified example.

In real life, situations tend to be more nuanced with elements like initial direct costs and guaranteed vs unguaranteed residual value. However, the formula to calculate the Net Investment in the Lease balance remains the same.

Calculation of Implied/Implicit Interest Rate

We now know the Net Investment in the Lease balance, which is $8,000. We also know the cash inflow schedule for the next 3 years:

  • Year 1: $2,847 – lease payment
  • Year 2: $2,847 – lease payment
  • Year 3: $4,847 – lease payment + residual value

In order to calculate the interest income each year, we will need to figure out the implicit interest rate. This can be done using an IRR calculator. And the rate comes out to be 13.725%

IRR Calculator for implied interest rate - Direct Financing Lease

Initial recognition

Net Investment in the Lease = PV of lease receivable ($7,753) + PV of Residual Value ($1,728) – Profit ($1,481) = $8,000

Direct Financing Lease Journal Entry - Initial Recognition

The Oven Lease Company (Lessor) will debit or recognize a $8,000 asset – Net investment in the Lease based on the calculation above and remove or credit the equipment from the book ($8,000).

Year 1

Interest Income: Outstanding Net Investment $8,000 * interest rate 13.725% = $1,098

Principal Reduction: Payment $2,847 – Interest $1,098 = $1,749

Ending Net Investment Balance: $8,000 – $1,749 = $6,251

Direct Financing Lease Journal Entry - Year 1

The Oven Lease Company (Lessor) will debit cash for $2,847 for the lease payment, and credit Interest Income for $1,098. The difference, or the principal reduction of $1,749, is a credit to the Net Investment in the Lease.

Year 2

Interest Income: Outstanding Net Investment $6,251 * interest rate 13.725% = $858

Principal Reduction: Payment $2,847 – Interest $858 = $1,989

Ending Net Investment Balance: $6,251 – $1,989 = $4,262

Direct Financing Lease Journal Entry - Year 2

Similar to year 1, the lessor debits cash for $2,847 for the lease payment, and credits Interest Income for $858. The difference of $1,989 is a credit to the Net Investment in the Lease.

Year 3

Interest Income: Outstanding Net Investment $4,262 * interest rate 13.725% = $585

Principal Reduction: Payment $2,847 – Interest $585 = $2,262

Ending Net Investment Balance: $4,262 – $2,262 = $2,000

Direct Financing Lease Journal Entry - Year 3

Similar to year 1 and 2, the lessor debits cash for $2,847 for the lease payment, and credits Interest Income for $585. The difference of $2,262 is a credit to the Net Investment in the Lease, leaving the $2,000 residual value in the account balance.

Asset return

When Pho My Life Noodle Shop (Lessee) hands back the oven equipment to The Oven Lease Company (Lessor), this journal entry is recorded.

Direct Financing Lease Journal Entry - Year 3 Asset Return

In essence, the equipment is reintroduced to the lessor’s ledger (by a debit to Equipment for $2,000), while the outstanding amount in Net Investment in the Lease is also cleared (via a credit of $2,000).

To conclude, at the end of the lease term, the lessor will have recognized the interest income of $2,541 from the lease term. ($1,098 from year 1, $858 from year 2, and $585 from year 3). The equipment with a residual value of $2,000 is returned to the lessor’s book, and the Net investment in the Lease account is completely zeroed out at the end.

Here is the amortization of the Net Investment in the Lease account.

Direct Financing Lease Amortization Schedule

Key Takeaways

  • In a direct financing lease, the lessor recognizes only interest income, with no upfront profit recognition (unlike in sales-type leases).
  • At the commencement date, a Net Investment in the Lease account (asset account) is recognized, which combines the present value of lease payment receivable and the residual value of the asset, minus any profit.
  • Similarly to other amortizations, the Net Investment in the Lease account is amortized by the lease payment minus the interest income. The return of the asset from the lessee will also reverse the balance. As a result, by the end of the lease term, the Net Investment in the Lease account will be zeroed out.

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