Gross and Net Investment in Lease

Lessors recognize a lease receivable on their finance leases at an amount equal to the net investment in the lease. Net investment in the lease equals gross investment in the lease minus unearned finance income.

Gross investment in lease

Gross investment in lease (GIL) represents the total future lease payments that a lessor may receive over the lease term.

GIL = LPs + URV

Lease payments (LPs) include fixed payments (including in-substance fixed payments), variable payments linked to some index or rate, amounts due from exercise of the purchase option by the lessee and any penalties due to the lessor on termination option if those option are certain to be exercised by the lessee.

Unguaranteed residual value (URV) is the amount of residual value which is not guaranteed by any party of guaranteed only a party related to the lessor.

Net investment in lease and unearned finance income

Net investment in lease (NIL) equals the amount at which the lease receivable is recognized in the statement of financial position. It is determined by discounting the gross investment in lease at the rate of interest implicit in the lease. Review lease interest rates here.

Unearned finance income (UEFI) equals the difference between gross investment in lease and the net investment in lease.

Unearned Finance Income = GIL − NIL

Example

You work as an accounting analyst at a wind power company which has leased its power generation facility to the local government for 20 years at monthly annual lease rental of $10 million. The fair value of the facility at the commencement of the lease was $80 million. There are no initial direct costs and the residual value guarantee provided by your parent company is $5 million.

If we assume that the lease rentals will be paid at the end of each period, we can determine the implicit interest rate is 10.93%. You can verify this by using Excel RATE function i.e. RATE(20,-10,80).

At the commencement date of the lease, the gross investment in lease (GIL) would be $200 million.

GIL
= Lease Payments × Periods
= $10 million × 20
= $200 million

We have ignored the residual value guarantee because it provided by a related party.

If we discount the gross investment in lease at the implicit interest rate i.e. 10.93%, we would get $80 million which is the net investment in lease at the inception date. Unearned finance income is $120 million (=$200 million − $80 million). This is journalized as follows:

Gross investment in lease $200M
Unearned finance income $120M
PPE $80M

Subsequently, we would recognize finance income equal to the product of opening net investment in lease and the implicit rate.

Finance Income
= Opening NIL × Implicit Rate
= $80 million × 10.93%
= $8.74 million

Closing net investment in lease equals opening net investment in lease plus finance minus lease payments received.

Closing NIL
= Opening NIL + FI − LPs
= $80 million + $8.74 million − $10 million
= $78.74 million

This is recognized using the following journal entry:

Bank $10M
Gross investment in lease $10M
Uearned finance income $8.74M
Finance income $8.74M

The net impact of this journal entry can also be reflected as follows:

Bank $10M
Finance income $8.74M
Net investment in lease $1.26M

It is often useful to create a lease amortization schedule which shows us projected finance income and lease receivable balance at the end of each period.

Year Finance Income Lease Payments Closing NIL
0 80
1 8.74 10.00 78.74
2 8.61 10.00 77.35
3 8.45 10.00 75.80
4 8.29 10.00 74.09
5 8.10 10.00 72.19
6 7.89 10.00 70.08
7 7.66 10.00 67.74
8 7.40 10.00 65.14
9 7.12 10.00 62.26
10 6.81 10.00 59.07
11 6.46 10.00 55.52
12 6.07 10.00 51.59
13 5.64 10.00 47.23
14 5.16 10.00 42.39
15 4.63 10.00 37.02
16 4.05 10.00 31.07
17 3.40 10.00 24.47
18 2.67 10.00 17.14
19 1.87 10.00 9.01
20 0.99 10.00 (0.00)

by Obaidullah Jan, ACA, CFA and last modified on
Studying for CFA® Program? Access notes and question bank for CFA® Level 1 authored by me at AlphaBetaPrep.com

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