In the first part of this article series about capital lease accounting, we discussed accounting for the asset and related liability from the perspective of the lessee. Now we’ll turn to other side of the transaction to look at accounting from the lessor’s perspective.

1. Direct financing leases

If the selling price of the asset equals its cost on the books of the lessor, the lease is a direct financing lease, and the lessor will only realize interest income over the life of the lease. Unlike a sales-type lease, which we’ll describe later, there will be no gain right away.

In the article about capital lease accouting by lessees, we discussed the concept of present value of the lease payments. Lessor accounting utilizes the opposite concept - the exact value of all future lease payments are initially recorded as a lease receivable. In addition, the difference between the lease payments and the asset’s cost is recorded immediately as unearned interest revenue. The unearned account is treated as a contra-receivable. The lessor uses the effective interest method to reduce the unearned interest account over the life of the lease. The receivable is reduced dollar-for-dollar when lease payments are received.

Let’s look at the example from part I again. On January 1, 20X4, Friends Company leases a machine from XYZ Corporation (both fictitious entity) for 10 years. The annual lease payment is $10,000, and the interest rate used by XYZ Corporation for the contract is 8% (see the time value information from part I for this lease). If the asset also has a carrying value of $67,100 for XYZ, the company will account for the lease as a direct financing lease and will record the following journal entry at the beginning of the lease.

There is no revenue from the lease itself. When each payment is made, XYZ will multiply the carrying value of the receivable (receivable minus the unearned interest balance) by the interest rate to determine how much of the unearned interest revenue to recognize. For the first payment, $5,368 will be interest (i.e., 8% x [$100,000-$32,900]). The journal entry will have two parts - the first part will reduce the receivable, and the second part will convert some of the unearned interest revenue to earned interest revenue.

The new carrying value of the receivable will be $62,468 ($90,000 - $27,532).

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