ACCOUNTING FOR

DIRECT FINANCE LEASE

INTERNATIONAL FINANCIAL REPORTING STANDARD 16

SIR F, CPA, CTT, MRITAX, CEMP, MBA,

PH.D-BMIA (O.G)
LESSOR’S POINT OF
VIEW
 KEY CONCEPTS
INITIAL RECOGNITION:
• RECOGNIZED ASSETS FROM FINANCE LEASE AS RECEIVABLE (NET INVESTMENT
IN THE LEASE)
SUBSEQUENT MEASUREMENT:
• EFFECTIVE INTEREST METHOD (FAVORITE: AMORTIZATION)
• DIRECT FINANCING LEASE RECOGNIZES INTEREST INCOME
• NO MANUFACTURER’S OR DEALER’S PROFIT BECAUSE THE FV/SP = COST OF
LEASE ASSETS
• INDIRECT COST SHOULD BE CAPITALIZED
 ILLUSTRATION #1 WITH RESIDUAL VALUE
ON JANUARY 1, 2019, A LESSOR LEASED MACHINERY TO ANOTHER ENTITY WITH THE FOLLOWING
DETAILS:
Cost of Machinery 1,791,850
Annual Rental payable at the end of each year 500,000
Residual Value 400,000
Lease Term and Useful Life 4 Years
Implicit Rate BEFORE Initial Direct Costs 12%
Implicit Rate AFTER Initial Direct Costs 10%
PV of 1 at 12% for 4 Years 0.6355
PV of 1 at 10% for 4 Years 0.6830
PV of 1 at 12% for 4 Years 3.0373
PVOA of 1 at 10% for 4 Years 3.1699

INITIAL DIRECT COST PAID BY THE LESSOR ON JANUARY 1, 2019 AMOUNTED TO P66,300. THE
MACHINERY WILL REVERT TO THE LESSOR WHEN THE LEASE EXPIRES ON DECEMBER 31, 2022.
 GROSS INVESTMENT – DECEMBER 31, 2019
TOTAL LEASE PAYMENTS (500,000 * 4 YEARS) 2,000,000
RESIDUAL VALUE 400,000
PURCHASE OPTION -
GROSS INVESTMENT 2,400,000

NET INVESTMENT – DECEMBER 31, 2019

PV OF ANNUAL RENTALS (500K * 3.1699) 1,584,950 COST OF THE LEASE ASSETS 1,791,850
RESIDUAL VALUE (400K * 0.6830) 273,200 INITIAL DIRECT COST 66,300
GROSS INVESTMENT 1,858,150 GROSS INVESTMENT 1,858,150
 UNEARNED INTEREST INCOME – DECEMBER 31, 2019
GROSS INVESTMENT 2,400,000
NET INVESTMENT (1,858,150)
UNEARNED INTEREST INCOME 541,850

Lease Receivable @ Gross 2,400,000

Machinery @ Cost 1,791,850

Cash @ IDC 66,300

Unearned Interest Income 541,850

INTEREST INCOME AND CARRYING AMOUNT DEC. 31,2019
Date Collection Interest Income Principal CV of Net Investment

01-01-19 1,858,150
12-31-19 500,000 185,815 314,185 1,543,965
12-31-20 500,000 154,397 345,604 1,198,362
12-31-21 500,000 119,836 380,164 818,198
12-31-22 500,000 81,802 418,198 400,000

Unearned Interest Income 185,815

Interest Income 185,815

Cash 500,000
Lease Receivable 500,000
 DEC. 31, 2022 - FV OF DEC. 31, 2022 - FV OF
MACHINERY IS 400,000 MACHINERY IS 450,000

GRV/URV = Fair Value GRV/URV < Fair Value

MACHINERY 400,000 MACHINERY 400,000

LEASE RECEIVABLE 400,000 LEASE RECEIVABLE 400,000

DEC. 31, 2022 - FV OF DEC. 31, 2022 - FV OF

MACHINERY IS 300,000 MACHINERY IS 300,000

GRV < Fair Value URV < Fair Value

MACHINERY 300,000 MACHINERY 300,000

CASH 100,000 LOSS ON FINANCE LEASE 100,000
LEASE RECEIVABLE 400,000 LEASE RECEIVABLE 400,000
 ILLUSTRATION #2 BARGAIN PURCHASE OPTION
ON JANUARY 1, 2019, A LESSOR LEASED MACHINERY TO ANOTHER ENTITY WITH
THE FOLLOWING DETAILS:

Cost of Machinery 3,358,700

Purchase Option 500,000
Lease Term and Useful Life 5 Years
Implicit Interest Rate in the Lease 8%
PV of 1 at 8% for 5 Years 0.6806
PVOA of 1 at 8% for 5 Years 3.993
PV of Annuity of 1 at 8% for 5 Years 4.312

THE ANNUAL RENTAL IS PAYABLE IN ADVANCE ON JANUARY 1 OF EACH YEAR

STARTING JANUARY 1, 2019. IT IS REASONABLY CERTAIN THAT THE LEASE WILL
EXERCISE THE PURCHASE OPTION AT THE EXPIRATION OF THE LEASE TERM.
 ANNUAL RENTALS PER LEASE CONTRACT
NET INVESTMENT
PV OF RENTALS (700,000 * 4.312) 3,018,400 (DIVIDED BY 4.312)
PV OF RESIDUAL VALUE -
PV OF PURCHASE OPTION (500K * .6806) 340,300
NET INVESTMENT 3,358,700 January 1, 2019

GROSS INVESTMENT Lease Receivable 4,000,000

Machinery 3,358,700
PV OF RENTALS (700,000 * 5 YEARS) 3,500,000
Unearned Int. Income 641,300
PV OF RESIDUAL VALUE -
Cash 700,000
PV OF PURCHASE OPTION 500,000
GROSS INVESTMENT 4,000,000 Lease Receivable 700,000
INTEREST INCOME AND CARRYING AMOUNT DEC. 31,2019
Date Collection Interest Income CV of Net Investment

01-01-19 - 3,358,700
01-01-19 700,000 2,658,700
12-31-19 700,000 212,696 2,171,396
12-31-20 700,000 173,712 1,645,108
12-31-21 700,000 131,609 1,076,716
12-31-22 700,000 86,137 462,854
12-31-23 37,146 500,000

Unearned Interest Income 212,696

Interest Income 212,696

Cash 700,000
Lease Receivable 700,000
ASSUMING THAT THE LESSEE EXERCISE THE PURCHASE
OPTION AT THE EXPIRATION OF THE LEASE TERM,
ENTRY ON THE BOOK OF THE LESSOR:

CASH 500,000
LEASE RECEIVABLE 500,000
 ASSUMING THAT THE LESSEE DO NOT EXERCISE THE
PURCHASE OPTION AT THE EXPIRATION OF THE LEASE
TERM, ENTRY ON THE BOOK OF THE LESSOR:
MACHINERY 500,000
LEASE RECEIVABLE 500,000
 ASSUMING THE PURCHASE OPTION IS NOT EXERCISED AND
THE FAIR VALUE OF THE MACHINE IS 350,000.

MACHINERY 350,000
LOSS ON FINANCE LEASE 150,000
LEASE RECEIVABLE 500,000

AMOUNT THAT SHOULD HAVE BEEN DEBITED MUST BE THE:

LOWER : ACTUAL FV VS PURCHASE OPTION
LESSEE’S POINT OF
VIEW
 ILLUSTRATION #1 WITH RESIDUAL VALUE
A COMPANY LEASED A MACHINERY ON JANUARY 1, 2020 WITH THE FOLLOWING INFORMATION:

Annual Rental payable at the end of each year 1,000,000

Residual Value - Guarantee 500,000
Payment to Lessor to obtain Long Term Lease 300,000
Cost of Dismantling and Restoring the asset at PV 390,000
Annual Executory Cost paid by the Lessee 50,000
Implicit Rate AFTER Initial Direct Costs 10%
Lease Term 4 Years
Useful Life 8 Years
Implicit Interest Rate 10%
PV of 1 at 10% for 4 Years 0.68
PVOA of 1 at 10% for 4 Years 3.17
 INITIAL LEASE LIABILITY ON JANUARY 1, 2020
PV OF ANNUAL RENTALS (1M * 3.17) 3,170,000
PV OF GUARANTEED RV (500K * 0.68) 340,000
PV OF PURCHASE OPTION -
INITIAL LEASE LIABILITY 3,510,000

COST OF RIGHT OF USE ASSET

INITIAL COST OF LEASE LIABILITY 3,510,000
LEASE PAYMENT ON OR BEFORE COMMENCEMENT 300,000
INCENTIVES -
INITIAL DIRECT COSTS -
DISMANTLING COSTS 390,000
RIGHT OF USE ASSET, 01/01/20 4,200,000
JANUARY 1, 2020

RIGHT OF USE ASSETS 4,200,000

LEASE LIABILITY 3,510,000
CASH 300,000
PROVISION ON DISMANTLING 390,000
 DEPRECIATION FOR 2020
COST OF RIGHT OF USE ASSET 4,200,000
LESS: GUARANTEED RESIDUAL VALUE (500,000)
DEPRECIABLE AMOUNT 3,700,000
DIVIDED BY: (LT VS UL) 4 YEARS
ANNUAL DEPRECIATION 925,000
12/12
ANNUAL DEPRECIATION 925,000
CARRYING AMOUNT OF LEASE LIABILITY ON DEC. 31, 2020
Date Interest Expense Lease Payment Principal CV of Lease Liability
(Cash) (Lease Liability)
01-01-20 3,510,000
12-31-20 351,000 1,000,000 649,000 2,861,000
12-31-21 286,100 1,000,000 713,900 2,147,100
12-31-22 214,710 1,000,000 785,290 1,361,810
12-31-23 138,190 1,000,000 861,810 500,000

Interest Expense 351,000

Lease Liability 351,000
Lease Liability 1,000,000
Cash 1,000,000
Depreciation Expense 925,000
Accumulated Depreciation - RoU 925,000
 CARRYING AMOUNT OF RIGHT OF USE ASSET

Date Depreciation Accumulated Carrying Value of Right

Expense Depreciation of Use Asset

1-1-2020 4,200,000
12-31-2020 925,000 925,000 3,275,000
12-31-2021 925,000 1,850,000 2,350,000
12-31-2022 925,000 2,775,000 1,425,000
12-31-2023 925,000 3,700,000 500,000
ASSUMING THAT THE FAIR VALUE OF THE MACHINERY
IS 520,000, WHAT IS THE ENTRY TO RECORD THE
RETURN OF EQUIPMENT TO THE LESSOR

LEASE LIABILITY 500,000

RIGHT OF USE ASSET 500,000
ASSUMING THAT THE FAIR VALUE OF THE MACHINERY
IS 450,000, WHAT IS THE ENTRY TO RECORD THE
RETURN OF EQUIPMENT TO THE LESSOR

LEASE LIABILITY 500,000

RIGHT OF USE ASSET 500,000

LOSS ON FINANCE LEASE 50,000

CASH 50,000
 ILLUSTRATION #2 BARGAIN PURCHASE OPTION
ON JANUARY 1, 2018, A COMPANY LEASED A BUILDING FROM A LESSOR WITH THE FOLLOWING
INFORMATION
Annual Rental payable at the end of each year 1,000,000
Initial Direct Cost 400,000
Lease Incentive Received 100,000
Leasehold Improvement 200,000
Purchase Option that is reasonably certain to be exercised 500,000
Implicit Interest Rate 10%
Lease Term 5 Years
Useful Life 8 Years
Implicit Interest Rate 10%
PV of 1 at 10% for 5 Years 0.62
PVOA of 1 at 10% for 5 Years 3.79
 ANSWER THE FOLLOWING QUESTIONS

1. COST OF RIGHT OF USE ASSET

2. DEPRECIATION FOR 2018
3. INTEREST EXPENSE FOR 2018
4. LEASE LIABILITY FOR DECEMBER 31, 2018
5. JOURNAL ENTRY IF THE LESSEE EXERCISED THE PURCHASE OPTION
6. JOURNAL ENTRY IF THE LESSEE DID NOT EXERCISED THE PURCHASE
OPTION
THANK YOU! 