Corporate Financial Reporting · Leases (Ind AS 116)

Lessor Accounting under Ind AS 116: Finance and Operating Leases

Updated 11 October 2026 · Fact-checked

A lessor first classifies each lease as finance or operating, based on whether it transfers substantially all risks and rewards of ownership. For a finance lease, derecognise the asset, record a net investment and recognise finance income at a constant rate. For an operating lease, keep the asset and recognise rent.

Understand Lessor Accounting: Finance and Operating Leases

Lessee accounting under Ind AS 116 uses one model. Lessor accounting does not. The lessor must classify every lease at inception as either a finance lease or an operating lease. The test is about substance: does the lease transfer substantially all the risks and rewards incidental to ownership of the underlying asset? If yes, it is a finance lease. If no, it is an operating lease.

Indicators of a finance lease include: ownership passes to the lessee at the end of the term, a purchase option that is reasonably certain to be exercised, a lease term covering the major part of the asset's economic life, present value of lease payments amounting to substantially all of the asset's fair value, and a specialised asset that only the lessee can use without major modification. These are indicators, not a checklist where one tick decides. Judge the whole picture.

In a finance lease, the lessor treats the transaction like a sale financed by a loan. It removes the asset from its books and shows a receivable called the net investment in the lease. This is the present value of lease payments and unguaranteed residual value, discounted at the rate implicit in the lease. Initial direct costs are included in this figure automatically through the implicit rate. Each receipt reduces both the principal and the unearned finance income. Finance income is recognised over the lease term at a constant periodic rate of return on the net investment.

In an operating lease, the lessor keeps the asset in its balance sheet, depreciates it as usual, and recognises lease income, normally on a straight-line basis over the term, unless another systematic basis better reflects the pattern of use. Initial direct costs are added to the asset's carrying amount and expensed over the lease term on the same basis as the income.

A manufacturer or dealer lessor offers customers a choice of buying or leasing. A finance lease gives it the same profit or loss as an outright sale at normal selling prices. At commencement it recognises revenue, cost of sale and selling profit. Selling profit is recognised at commencement even if the asset is not transferred as Ind AS 115 would require. Its finance income is recognised afterwards over the lease term.

Key rules to remember

Net investment in the lease: Net investment = PV of lease payments receivable + PV of unguaranteed residual value (at the rate implicit in the lease); Gross investment less unearned finance income equals net investment.
Unearned finance income: Unearned finance income = Gross investment − Net investment; Gross investment = lease payments receivable by the lessor + unguaranteed residual value.
Finance income for a period: Finance income = Opening net investment × Implicit rate; Receipts reduce both principal and unearned finance income. Closing net investment = Opening + Finance income − Receipt.
Dealer lessor: revenue: Revenue = Lower of (fair value of asset, PV of lease payments accruing to lessor at a market rate); Per paragraph 71(a).
Dealer lessor: cost of sale: Cost of sale = Cost (or carrying amount) of asset − PV of unguaranteed residual value; Per paragraph 71(b).
Dealer lessor: selling profit: Selling profit = Revenue − Cost of sale; Recognised at commencement. If the quoted rate is artificially low, restrict profit to that under a market rate (paragraph 73).
Selling costs of dealer lessor: Costs of obtaining a finance lease are expensed at commencement; Paragraph 74. They are excluded from initial direct costs and from net investment.

How to solve Lessor Accounting: Finance and Operating Leases questions

Use this order for any lessor question, whether it is theory or a numerical.

1Read the facts and classify the lease: check ownership transfer, purchase option, lease term versus economic life, PV versus fair value, and specialised asset.
2If it is an operating lease, keep the asset, charge depreciation, and recognise rent on a straight-line basis. Add initial direct costs to the asset and spread them.
3If it is a finance lease, find the implicit rate. Often it is given, or you solve it from fair value equals PV of payments plus PV of residual.
4Compute gross investment, net investment and unearned finance income at commencement.
5Prepare a table: opening net investment, finance income at the implicit rate, receipt, closing net investment, for each year.
6For a manufacturer or dealer lessor, compute revenue, cost of sale and selling profit at commencement. Expense selling costs immediately.
7Write the journal entries: lease receivable (net investment) on commencement, bank and finance income on each receipt.
8Check the closing net investment in the last year equals the residual value to be realised, or nil if none.

Quickest way: Classify, tabulate, then post

When to use it: Use it in the 14-mark written question when the implicit rate is given and time is short.

Decide the class in one line, naming the indicator that decides it, such as lease term covering the major part of life.
Net investment at start equals PV of receipts plus PV of residual, or fair value if the rate was derived from it.
Fill a four-column table. Income equals opening balance times rate. Closing equals opening plus income minus receipt.
Check that the last closing balance equals the residual or zero. This catches arithmetic errors.
For a dealer, write revenue, cost of sale and profit in three lines before the table.

Common mistakes in Lessor Accounting: Finance and Operating Leases

Classifying by legal form, calling a lease operating because title does not pass.
Students recall the old rule that finance leases always transfer title.
Fix: Apply the risks and rewards test. A lease can be a finance lease without title passing, for example when the term covers the major part of the asset's life.
Recognising finance income on a straight-line basis.
Straight-line is used for operating lease rent, and students carry it over.
Fix: Finance income follows a constant periodic rate of return on the net investment, so it falls as the balance falls.
Reducing only principal by the receipt and ignoring unearned income.
Students treat the receipt like a loan instalment without splitting it.
Fix: Split each receipt into finance income and principal repayment using the table. Receipts reduce both principal and unearned finance income.
Deducting full cost in the dealer's cost of sale without adjusting for unguaranteed residual value.
Students copy the outright sale formula.
Fix: Cost of sale equals cost less PV of the unguaranteed residual value.
Capitalising a dealer lessor's selling costs in net investment.
Students apply the general rule on initial direct costs.
Fix: A manufacturer or dealer lessor expenses costs of obtaining a finance lease at commencement. They are not initial direct costs.
Taking dealer profit on the fair value even when the lessor quotes an artificially low rate.
Students overlook the restriction in the standard.
Fix: Revenue is the lower of fair value and PV of lease payments at a market rate, and selling profit is restricted to that under a market rate.

Worked examples

Example 1

Sunrise Leasing Ltd leases a machine to Kaveri Textiles Ltd on 1 April 2026 for 3 years. The machine costs ₹10,00,000 and its fair value is ₹10,00,000. Annual lease payments of ₹4,02,115 are receivable at the end of each year. There is no residual value. The lease transfers substantially all risks and rewards. The implicit rate is 10%. Show the classification, net investment and finance income for each year.

Show the solution

Classification: the present value of the lease payments equals the machine's fair value of ₹10,00,000. So the payments cover substantially all of the fair value, and the lease transfers substantially all risks and rewards. It is a finance lease.
Net investment at commencement is ₹10,00,000, the fair value, since the implicit rate is derived from it. Gross investment is 3 × ₹4,02,115 = ₹12,06,345. Unearned finance income is ₹2,06,345.
Year 1: finance income = 10,00,000 × 10% = ₹1,00,000. Closing = 10,00,000 + 1,00,000 − 4,02,115 = ₹6,97,885.
Year 2: finance income = 6,97,885 × 10% = ₹69,789 (rounded to the nearest rupee). Closing = 6,97,885 + 69,789 − 4,02,115 = ₹3,65,559.
Year 3: finance income = 3,65,559 × 10% = ₹36,556 (rounded to the nearest rupee). Closing = 3,65,559 + 36,556 − 4,02,115 = ₹0.
Journal at commencement: Lease receivable (net investment) Dr ₹10,00,000, to Machine ₹10,00,000.
Journal each year: Bank Dr ₹4,02,115, to Finance income (that year's amount from the table) and to Lease receivable (the balance of the receipt).

Answer: It is a finance lease. Net investment is ₹10,00,000. Finance income is ₹1,00,000, ₹69,789 and ₹36,556 in years 1 to 3, totalling ₹2,06,345. The closing net investment after year 3 is nil.

Example 2

Bharat Motors Ltd, a dealer, leases a vehicle on a finance lease. Cost is ₹8,00,000 and fair value is ₹10,00,000. Lease payments have a present value of ₹9,50,000 at a market rate. There is no unguaranteed residual value. Selling costs of ₹15,000 were incurred to arrange the lease. Compute the amounts recognised at commencement.

Show the solution

Revenue is the lower of fair value ₹10,00,000 and PV of lease payments ₹9,50,000. So revenue is ₹9,50,000.
Cost of sale is cost ₹8,00,000 less PV of unguaranteed residual value, which is nil. So it is ₹8,00,000.
Selling profit = 9,50,000 − 8,00,000 = ₹1,50,000, recognised at commencement.
Selling costs of ₹15,000 are expensed at commencement. They are not part of net investment.
Net investment recognised is ₹9,50,000. The vehicle is derecognised at its cost of ₹8,00,000. Finance income is recognised afterwards over the lease term at a constant rate.
Entry at commencement: Lease receivable (net investment) Dr ₹9,50,000; Cost of sale Dr ₹8,00,000; to Revenue ₹9,50,000; to Vehicle (inventory) ₹8,00,000.
Entry for selling costs: Selling expense Dr ₹15,000, to Bank ₹15,000.

Answer: Revenue ₹9,50,000; cost of sale ₹8,00,000; selling profit ₹1,50,000. Selling costs of ₹15,000 are expensed. Net investment is ₹9,50,000.

Exam tips

Always state the classification with the deciding indicator. Marks are given for reasoning, not only for the label.
Show the table of opening balance, income, receipt and closing balance. Even with an arithmetic slip, you earn method marks.
In dealer problems, write revenue, cost of sale and profit as three separate lines and say that selling costs are expensed.
For MCQs, remember that finance income uses a constant rate on net investment and that dealer selling profit is recognised at commencement.
If the question gives a low interest rate by the dealer, recompute at the market rate and restrict profit.

Practice questions from Leases (Ind AS 116)

Lessor Accounting: Finance and Operating Leases in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Lessor Accounting: Finance and Operating Leases: frequently asked questions

How does a lessor classify a lease under Ind AS 116?

The lessor classifies it at inception. If it transfers substantially all the risks and rewards incidental to ownership of the underlying asset, it is a finance lease. Otherwise it is an operating lease.

What is net investment in the lease?

It is the gross investment discounted at the rate implicit in the lease. Gross investment is the lease payments receivable plus any unguaranteed residual value. The difference between gross and net investment is the unearned finance income.

When does a dealer lessor recognise selling profit?

It recognises selling profit or loss at the commencement date for a finance lease, in line with its policy for outright sales. If the interest rate quoted is artificially low, profit is restricted to that under a market rate.

Are a dealer lessor's selling costs part of net investment?

No. Costs incurred by a manufacturer or dealer lessor in obtaining a finance lease are expensed at commencement. They are excluded from initial direct costs and therefore from net investment.