The sum of the undiscounted minimum lease payments (MLPs) to be made on a finance lease plus any unguaranteed residual value (URV) accruing to the lessor is the gross investment in a finance lease.  At inception of a direct-financing lease, the lessor recognizes a lease receivable – a financial asset, not the underlying fixed asset – equal to its gross investment in the leased asset.  Lessors present assets subject to operating leases in their balance sheet according to the nature of the asset.

Gross Investment = Minimum Lease Payments + Unguaranteed Residual Value

At inception of a direct-financing lease, the net investment is the balance sheet asset equal to the present value of the lease receivable (gross investment) plus unamortized initial direct costs in a lease discounted at the implicit interest rate, it representing substantially all of the fair value of the leased asset.

Lessor Recognition of a Direct Financing Lease – Gross Method
Date Lease Receivable (Gross Investment) xxxx
Leased Asset (Net Investment) xxxx
Unearned Interest Income (Gross - Net) xxxx
To record a finance lease at inception

For a sales-type lease, the asset’s cost plus the initial direct cost less the present value of any unguaranteed residual value (URV) is charged (expensed) against income in the same period the present value of the MLPs is credited to sales, resulting in a profit or loss on the sale.

The difference between the lease receivable (gross investment) and the leased asset (net investment) is recorded at inception of a finance lease in a contra account as unearned interest income to be recognized as revenue and amortized over the lease term using the effective-interest method.  The total interest earned over the lease term – assuming no impairment loss – is equal to the unearned interest at the beginning of the lease term.

Unearned Interest Revenue = Gross Investment - Net Investment
or
Unearned Interest Revenue = Lease Receivable - Leased Asset

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