Finance lease receivable: net investment and finance income

The net investment in finance leases is usually the largest asset of a leasing company and finance income is its main revenue line. Small errors in building the net investment compound over the portfolio: excluding the unguaranteed residual value, expensing initial direct costs that IFRS 16 includes in the net investment, using a contractual 'flat rate' instead of the implicit rate, or recognising income on a straight-line or 'rule of 78' basis instead of a constant periodic rate all misstate both the receivable and the yield. Because the implicit rate is defined to include initial direct costs, those costs are not added on top; they are already inside the rate and are recognised as a reduction of income over the lease term.

Is the net investment measured as the present value of lease payments not yet received plus the present value of the unguaranteed residual value, discounted at the interest rate implicit in the lease? Is the implicit rate computed so that this present value equals the fair value of the asset plus the lessor's initial direct costs? Which costs are treated as initial direct costs (broker commissions, legal fees, incremental sales commissions) and which are excluded (general overheads, salaries of the sales team not incremental to the lease)? Is finance income recognised at a constant periodic rate on the outstanding net investment, and does the system do this or does it use the flat-rate schedule shown to customers? Are payments received in advance at or before commencement excluded from the receivable?

1. At commencement, derecognise the underlying asset and recognise a receivable at the net investment in the lease.
2. Identify the lease payments included: fixed payments (including in-substance fixed) less lease incentives payable, variable payments that depend on an index or rate measured at the commencement-date index or rate, the exercise price of a purchase option the lessee is reasonably certain to exercise, termination penalties if the term reflects termination, and residual value guarantees from the lessee, its related parties or a financially capable third party.
3. Add the unguaranteed residual value.
4. Discount at the interest rate implicit in the lease, which by definition equates the present value of these amounts with the fair value of the asset plus the lessor's initial direct costs, so initial direct costs are automatically included in the net investment.
5. Recognise finance income over the lease term at a constant periodic rate of return on the net investment; apply lease payments received against the gross investment, reducing both principal and unearned finance income.
6. Recognise variable payments not included in the net investment (for example usage-based charges) as income when they arise.
7. Apply IFRS 9 derecognition and impairment requirements to the net investment (see BANK-084).

Net investment = present value of lease payments receivable + present value of unguaranteed residual value, at the implicit rate. Gross investment = undiscounted lease payments receivable + undiscounted unguaranteed residual value; the difference is unearned finance income. Initial direct costs are incremental costs that would not have been incurred had the lease not been obtained; the exception for manufacturer or dealer lessors (who expense them) does not normally apply to a pure leasing company. After commencement, the carrying amount is the opening net investment plus finance income at the implicit rate less payments received, less the IFRS 9 loss allowance. The implicit rate is fixed at commencement and changes only through a modification accounted for under IFRS 16 or IFRS 9. IFRS 16 does not specify how a finance lessor reflects later changes in index-linked payments, so the policy (commonly recognising the effect in profit or loss as it arises) should be stated and applied consistently.

Disclose: (1) finance income on the net investment in the lease; (2) income from variable lease payments not included in the net investment; (3) a qualitative and quantitative explanation of significant changes in the carrying amount of the net investment; (4) a maturity analysis of undiscounted lease payments receivable for each of the first five years and a total for the remaining years, reconciled to the net investment by showing unearned finance income and the discounted unguaranteed residual value; (5) the accounting policy for initial direct costs and the implicit rate.

• Using the advertised flat rate to compute income, which front-loads or back-loads profit compared with the constant-rate method
• recognising the gross receivable (including unearned income) as the asset
• omitting the unguaranteed residual value from the net investment
• expensing broker commissions that are initial direct costs, or capitalising internal overheads that are not
• adding initial direct costs on top of a net investment already computed at the implicit rate, counting them twice
• recognising upfront administration fees charged to the lessee as income on day one when they form part of the lease payments
• measuring index-linked payments at forecast index levels rather than at the index at commencement