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Accounting for leases

At lease commencement, the supplier (lessor) would record the following journal entries.

Dr. Lease receivable $9,091

Dr. Cost of goods sold $80,000

Cr. Inventory $80,000

Cr. Revenue $9,091

The $70,909 loss at the commencement of the lease ($80,000 - $9,091) occurs due to the exclusion of
variable payments from contract consideration. The rate implicit in the lease is negative because the
sum of (1) the lease payments ($9,091) and (2) the estimated residual value of the machine at the end
of the lease term ($0) is less than the machine’s fair value at the lease commencement date
($100,000). However, it would not be appropriate for a lessor to use a negative discount rate as the
rate implicit in the lease. Therefore, the lessor must use a rate of 0% and not discount the receivable.

4.3.2 Direct financing lease

As described in ASC 842-30-25-7, a lessor should derecognize the leased asset underlying a direct
financing lease and record a net investment in the lease at lease commencement. The net investment
in the lease should be measured in the same manner as a sales-type lease adjusted for selling profit
and initial direct costs. See LG 4.3.1 for information on measuring the net investment in a sales-type
lease. Any selling profit and initial direct costs should be deferred and included in the net investment
in the lease. These amounts should be recognized over the lease term in a manner that will produce,
when combined with the interest income on the lease receivable and the residual asset, a constant
periodic rate of return on the lease. Selling losses should not be deferred; they should be recognized
using the impairment guidance for inventory or property, plant, and equipment, as applicable.

4.3.2.1 Initial measurement of net investment in the lease

ASC 842-30-30-2 provides guidance of the measurement of the net investment in a direct financing
lease. (Note that ASC 842-30-30-1(a) and 30-1(b) are reproduced in LG 4.3.1.)

ASC 842-30-30-2
At the commencement date, for a direct financing lease, a lessor shall measure the net investment in
the lease to include the items in paragraph 842-30-30-1(a) through (b), reduced by the amount of any
selling profit.

Selling profit is not recognized at the commencement of a direct financing lease because it does not
transfer control of the underlying asset to the lessee. This treatment is consistent with the principle of
a sale in ASC 606. However, when a lease meets the criteria to be classified as a direct financing lease,
it transfers substantially all the risks and rewards of ownership of the underlying asset to one or more
third parties and effectively converts the lessor’s risk arising from the underlying asset into credit risk.
Therefore, the most faithful representation of a lessor’s involvement in such a lease is to recognize the
lessor’s financial net investment in the lease (excluding selling profit) and recognize selling profit as
interest income on that net investment.

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