In a direct financing lease, how does the lessor typically account for profit and costs?

In a direct financing lease, how does the lessor typically account for profit and costs?

• A. The lessor recognizes sales profit upfront and amortizes initial direct costs.
• B. The lessor defers all profits until lease term ends.
• C. The lessor records profit only at end of year.
• D. The lessor records profit only when cash is received.

Answer: (B)

In a direct financing lease, the lessor’s return is driven by financing income rather than an upfront sale profit. At inception the asset is removed from the lessor’s books and a net investment in the lease is recorded, equal to the present value of the lease payments plus any unguaranteed residual value. There is typically no gross profit recognized at the start. Instead, the profit portion is earned gradually as interest income over the lease term, using the effective interest method as the net investment is collected. Initial direct costs are capitalized and amortized over the lease term. This is why the concept described is that profits are deferred and recognized over the life of the lease, not upfront.

In a direct financing lease, the lessor’s return is driven by financing income rather than an upfront sale profit. At inception the asset is removed from the lessor’s books and a net investment in the lease is recorded, equal to the present value of the lease payments plus any unguaranteed residual value. There is typically no gross profit recognized at the start. Instead, the profit portion is earned gradually as interest income over the lease term, using the effective interest method as the net investment is collected. Initial direct costs are capitalized and amortized over the lease term. This is why the concept described is that profits are deferred and recognized over the life of the lease, not upfront.