Direct Financing Lease Accounting for Lessors
A direct financing lease is a lessor classification in ASC 842. It covers a lease that fails every sales-type test in ASC 842-10-25-2 but passes the two tests in ASC 842-10-25-3(b). The first test counts residual value guaranteed by the lessee or an unrelated third party. The second requires collectibility to be probable.
The lessor swaps the asset for a net investment in the lease, as a sales-type lessor does. The difference is timing: any selling profit is deferred and earned as interest over the term.
Most of this site is written from the lessee's desk. This page sits on the other side of the contract. If you want the lessee view of the same tests, start with how lease classification works for lessees.
What are the direct financing lease criteria?
The lessor runs the tests in order. ASC 842-10-25-2 comes first, with five tests. They cover transfer of ownership and a purchase option the lessee is reasonably certain to exercise. They also cover a major part of economic life, present value against fair value, and a specialized asset.
Meet any one and the lease is sales-type. The lessee applies the same tests and will often reach finance lease, though not always: it may use a different discount rate and residual assumptions (Deloitte Roadmap: Leasing, section 9.2).
If none is met, ASC 842-10-25-3(b) decides between direct financing and operating. Both conditions must hold:
- Present value: take the lease payments plus residual value guaranteed by the lessee (if not already in the lease payments) and/or any other third party unrelated to the lessor. Their present value equals or exceeds substantially all of the asset's fair value.
- Collectibility: it is probable the lessor will collect the lease payments plus any amount needed to satisfy a residual value guarantee.
The main new input is the third-party guarantee. The lessee's own guarantee already counted in the sales-type test. So a lease lands here when an outside guarantor, such as a residual value insurer, pushes the present value over the line.
The discount rate needs care. ASC 842-10-25-4 has the lessor use the rate implicit in the lease for both present value tests. In the sales-type test that rate leaves out initial direct costs when fair value differs from carrying amount. In the direct financing test it always includes them, so the two rates can differ (KPMG Handbook: Leases, paragraph 7.2.80).
Two further rules shape the result. The KPMG Handbook (paragraph 7.2.70) notes a lessor may use 90% as the threshold for "substantially all." And ASC 842-10-25-3A overrides both sets of tests. A lease with variable payments that do not depend on an index or a rate is operating if classifying it as sales-type or direct financing would produce a selling loss at commencement.
Direct financing lease vs sales-type lease: what changes on the books?
The balance sheet looks almost the same. In both, the lessor derecognizes the asset and records a net investment in the lease. That net investment is a lease receivable plus an unguaranteed residual asset, both discounted at the rate implicit in the lease, per ASC 842-30-30-1.
The income statement is where they split:
| Item | Sales-type lease | Direct financing lease |
|---|---|---|
| Selling profit | Recognized at commencement (ASC 842-30-25-1) | Deferred, netted against the net investment (ASC 842-30-25-8, 842-30-30-2) |
| Selling loss | Recognized at commencement | Recognized at commencement (ASC 842-30-25-7) |
| Initial direct costs | Expensed if fair value differs from carrying amount; otherwise deferred | Always deferred into the net investment (ASC 842-30-25-8) |
| After commencement | Interest income at a constant periodic rate on the net investment (ASC 842-30-35-1) | |
Why defer the profit? The Board's reasoning, as the KPMG Handbook: Leases explains it (paragraphs 7.3.90–7.3.110, drawing on ASU 2016-02 BC95, BC96 and BC98), is that the lessee does not obtain control of the asset. The lessor has turned asset risk into credit risk, so it earns financing income rather than a sale margin. A selling loss still hits day one, because it may signal the asset was already impaired.
How does the deferred profit change the interest rate?
This is the step most people miss. Deferred profit makes the net investment smaller than the receivable plus the residual. ASC 842-30-35-1(a) wants interest at a constant rate on that smaller balance. So the lessor needs a second rate.
The Codification's own illustration shows how. In ASC 842-30-55-35, interest is the opening net investment times a second rate. That rate is "the discount rate that, at the commencement date, would have resulted in the sum of the lease receivable and the unguaranteed residual asset equaling" the net investment.
The receivable and residual still accrete at the original rate implicit in the lease. The gap between the two is the deferred profit released that year (ASC 842-30-55-36).
A worked direct financing lease, with every input stated
The figures are our own; the method follows the Codification's Example 1, Case C (ASC 842-30-55), as reproduced in KPMG's Handbook: Leases. A manufacturer leases a machine it built. These are the facts at commencement:
| Input | Amount |
|---|---|
| Fair value of the machine | $100,000 |
| Carrying amount (inventory) | $92,000 |
| Lease term | 4 years |
| Remaining economic life | 8 years |
| Payments | $22,000 a year, in arrears |
| Expected residual value at end of term | $30,000 |
| Residual guaranteed by an unrelated insurer | $25,000 |
| Residual guaranteed by the lessee | $0 |
| Initial direct costs, prepaid payments | None |
| Collectibility of payments and guarantee | Probable |
| Rate implicit in the lease | 5.998% |
The 5.998% rate makes four $22,000 payments plus the $30,000 residual worth exactly $100,000 today. No title transfer, no purchase option, no specialized asset. Four of eight years is not a major part of the economic life.
| Step | Calculation | Result |
|---|---|---|
| Sales-type PV test | PV of payments $76,236 ÷ $100,000 | 76%: fails |
| Direct financing PV test | ($76,236 + PV of $25,000 guarantee $19,804) ÷ $100,000 | 96%: passes |
| Classification | PV test passes and collectibility is probable | Direct financing lease |
| Lease receivable | $76,236 + $19,804, less $1 rounding | $96,039 |
| Unguaranteed residual asset | PV of $5,000 at 5.998% | $3,961 |
| Selling profit, deferred | $96,039 − ($92,000 − $3,961) | $8,000 |
| Net investment in the lease | $96,039 + $3,961 − $8,000 | $92,000 |
| Income rate on net investment | Rate that makes the same cash flows worth $92,000 | 9.226% |
Here is the amortization schedule. Figures here and in the journal entries below are rounded to whole dollars.
| Year | Opening net investment | Interest income at 9.226% | Payment | Closing net investment | Of which: at 5.998% on receivable and residual | Of which: deferred profit released | Deferred profit left |
|---|---|---|---|---|---|---|---|
| 1 | $92,000 | $8,488 | $22,000 | $78,488 | $5,998 | $2,490 | $5,510 |
| 2 | $78,488 | $7,241 | $22,000 | $63,729 | $5,038 | $2,203 | $3,307 |
| 3 | $63,729 | $5,879 | $22,000 | $47,608 | $4,021 | $1,858 | $1,449 |
| 4 | $47,608 | $4,392 | $22,000 | $30,000 | $2,943 | $1,449 | $0 |
| Total | $26,000 | $88,000 | $18,000 | $8,000 |
Check the totals. Cash of $88,000 plus a $30,000 residual, less the $92,000 net investment, is $26,000 of income. A sales-type lessor would book the same $26,000. It would just take $8,000 of it on day one and $18,000 as interest.
What are the direct financing lease journal entries?
At commencement the lessor removes the machine and books the two components. The deferred profit sits as a contra account, so the net investment reads $92,000.
| Commencement | Debit | Credit |
|---|---|---|
| Lease receivable | $96,039 | |
| Unguaranteed residual asset | $3,961 | |
| Inventory | $92,000 | |
| Deferred selling profit | $8,000 |
At the end of year 1 the lessor collects the payment and earns interest. The receivable earns $5,760 ($1 rounding) and the residual accretes $238, both at 5.998%. Together they make the $5,998 in the schedule.
| End of year 1 | Debit | Credit |
|---|---|---|
| Cash | $22,000 | |
| Unguaranteed residual asset | $238 | |
| Deferred selling profit | $2,490 | |
| Lease receivable ($22,000 − $5,760) | $16,240 | |
| Interest income | $8,488 |
At the end of year 4, the net investment equals the $30,000 expected residual. The lessor moves it back to equipment when the machine comes home, as the Codification does in ASC 842-30-55-39. If the machine is worth less, the insurer covers the shortfall up to $25,000. Compare the lessee's side of the ledger in operating vs. finance lease journal entries.
Why are direct financing leases uncommon?
The fact pattern is narrow. The lease has to fail every sales-type test, including present value on the lessee's payments and guarantee. Then an outside guarantee has to close the gap to substantially all.
One example is residual value insurance the lessor buys from an unrelated third party at or near commencement. Insurance bought later does not trigger reclassification (ASC 842-10-25-8; Deloitte Roadmap: Leasing, section 9.2).
The same Deloitte section describes the third-party guarantee as the feature that separates the two tests. It also notes that direct financing leases "are typically considered a financial product."
Many lessors also have no selling profit to defer. Take a lessor that is not a manufacturer or dealer. Its fair value at commencement is the asset's cost, net of volume or trade discounts, unless significant time has passed since it bought the asset (ASC 842-30-55-17A).
For a bank that buys equipment to lease, fair value then equals carrying amount. The direct financing label changes little on that bank's books.
What does the lessor disclose for a direct financing lease?
ASC 842-30-50-6 requires the components of the aggregate net investment in sales-type and direct financing leases. That means lease receivables, unguaranteed residual assets and any deferred selling profit on direct financing leases. After commencement, ASC 842-30-35-3 requires a loss allowance on the net investment in line with Subtopic 326-20.
For the broader picture of what now sits on balance sheets, see off-balance-sheet financing and lease liabilities. For how the implicit rate differs from a lessee's borrowing rate, see implicit rate vs. IBR for lessees. More lessee entries are in ASC 842 journal entries with examples.
Frequently asked questions
Is a direct financing lease the same as a finance lease?
No. A finance lease is a lessee classification. The lessor on the same contract has a sales-type lease if any test in ASC 842-10-25-2 is met. A direct financing lease exists only on the lessor side, for leases that fail those tests but pass ASC 842-10-25-3(b).
Why does a direct financing lease need a second interest rate?
Deferred selling profit makes the net investment smaller than the lease receivable plus the unguaranteed residual asset. The lessor accretes that smaller balance at the rate that would have made the two components equal it at commencement, as ASC 842-30-55-35 illustrates. The higher rate releases the deferred profit over the term.
Does a bank lessor have selling profit on a direct financing lease?
Usually not. Take a lessor that is not a manufacturer or dealer. Its fair value at commencement is the asset's cost, as ASC 842-30-55-17A states, unless significant time has passed since the lessor bought it. Fair value then equals carrying amount, so there is no profit to defer.
Sources and further reading
- KPMG Handbook: Leases, paragraph 5.6.50 (the three lessor discount rates) and chapter 7 (lessor classification, the net investment, Example 7.3.40, and the reproduced ASC 842-30-55 Example 1, Case C).
- Deloitte Roadmap: Leasing, section 9.2, Lease Classification.
- Deloitte Roadmap: Leasing, section 9.3, Recognition and Measurement.
- For the seller-lessee side of a related lessor topic, see what sellers in a sale-leaseback should know.
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