Direct financing lease definition
/What is a Direct Financing Lease?
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. 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.
Accounting for a Direct Financing Lease
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.
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Example of a Direct Financing Lease
Luminescence Corporation wants to acquire a $500,000 machine for its floodlight manufacturing facility. The company is currently cash-strapped, because it recently paid out a substantial sum to acquire an LED-manufacturing business. To make the purchase, Luminescence contacts DarkStar Leasing, which agrees to purchase the machine and then lease it to the company.
Under the terms of the lease, Luminescence will pay DarkStar $120,000 per year for five years, for a total of $600,000. By entering into this arrangement, Luminescence can avoid an up-front cash payment, while paying for the lease with the products sold using the new machine. DarkStar profits from the interest portion of the lease payments being made to it.
Under this leasing deal, DarkStar is only providing financing to Luminescence - it does not provide any maintenance or other services. This means that the arrangement can be classified as a direct financing lease, so DarkStar recognizes a lease receivable that equates to the present value of the minimum lease payments, while Luminescence recognizes the machine as a fixed asset, with an offsetting lease obligation. Over the term of the lease, Luminescence will depreciate the machine, and also recognize interest expense on the lease arrangement. At the same time, DarkStar will recognize interest income on the lease payments being made to it.
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