A 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. Under this arrangement, the lessor recognizes the gross investment in the lease and the related amount of unearned income. The gross investment in the lease is calculated as:
Sum of minimum lease payments, less executory cost component
+ Unguaranteed residual value benefiting lessor
The amount of unearned income is the difference between the gross investment in the lease and its carrying amount.
Unearned income is recognized in earnings over the term of the lease. The lessor uses the interest method to recognize that amount of unearned income that produces a constant rate of return over the lease term.
At least once a year, the lessor reviews the estimated residual value of the leased property. If the residual value has declined and the decline is other than temporary, account for the decline as a loss in the current period. If the residual value has increased, do not recognize a gain.
A direct financing lease is usually offered by financing institutions, such as equipment leasing companies. Under this leasing arrangement, the lessor cannot be a manufacturer or dealer.