Financial Accounting · Lease Accounting

Accounting for Finance Leases in Books of Lessor

Updated 10 October 2026 · Fact-checked

In a finance lease, the lessor derecognises the asset and records a lease receivable equal to the net investment in the lease: gross investment less unearned finance income. Each lease payment reduces the receivable. Finance income is recognised at a constant periodic rate on the outstanding net investment, so interest falls each year while principal repayment rises.

Understand Accounting for Finance Leases in Books of Lessor

A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset (AS 19, para 3.2). Because the lessor has effectively sold the asset and financed the buyer, it does not keep the asset in its books as its own. It shows a receivable instead.

The receivable is not the asset's cost. AS 19 (para 26) says the lessor recognises the asset given under a finance lease as a receivable at an amount equal to the net investment in the lease. Net investment is the gross investment less unearned finance income (para 3.16). Gross investment is the total of minimum lease payments receivable plus any unguaranteed residual value accruing to the lessor. The difference between gross investment and the amount actually invested is the total finance income the lessor will earn over the lease.

Each lease payment has two parts. Para 27 treats it as repayment of principal (the net investment) and finance income, which rewards the lessor for its investment and services. So a rupee received is not all income. Only the finance income part goes to the Statement of Profit and Loss.

Para 28 and 29 fix the pattern. Finance income is recognised to give a constant periodic rate of return on the net investment outstanding. Lease payments for the period, excluding charges for services, are reduced from both the principal and the unearned finance income. In practice you build a schedule: opening net investment, finance income at the rate, payment, closing net investment. Income is highest in year 1 and falls as the net investment falls.

A manufacturer or dealer lessor earns two kinds of income (para 33): the profit or loss equal to an outright sale at normal selling prices, and finance income over the lease term. The selling profit is recognised at inception. The finance income is spread over the term.

Key rules to remember

Gross investment in the lease: Gross investment = Minimum lease payments receivable + Unguaranteed residual value (accruing to lessor); With no unguaranteed residual value, it is just the total of the lease payments receivable.
Net investment in the lease (para 3.16): Net investment = Gross investment − Unearned finance income; This is the amount shown as lease receivable (para 26). It equals the present value of the gross investment at the rate implicit in the lease.
Unearned finance income: Unearned finance income = Gross investment − Present value of gross investment at the implicit rate; Total finance income over the lease term. It is recognised gradually, not at inception.
Finance income for a period (paras 28, 29): Finance income = Opening net investment × Implicit rate (for the period); Constant periodic rate on the net investment outstanding. For payments at year end, opening net investment is the balance after the previous payment.
Closing net investment: Closing net investment = Opening + Finance income − Lease payment received; The payment reduces both the receivable and the unearned finance income (para 29).
Annual payment from present value: Annual payment = Net investment ÷ Annuity factor (rate, years); Use when the question gives fair value and rate but not the instalment. For 10% and 3 years the factor is about 2.48685 for payments at year end.
Residual value rule (para 30): Reduction in estimated unguaranteed residual value: revise income, recognise reduction immediately. No upward adjustment.; Applies when the unguaranteed residual value is reviewed.

How to solve Accounting for Finance Leases in Books of Lessor questions

Use this order for any lessor finance lease question. It keeps the schedule, the journal entries and the disclosures consistent.

1Confirm it is a finance lease: substantially all risks and rewards pass to the lessee. If the question says so, move on.
2Find the net investment at inception. This is usually the fair value or cost of the asset, or the present value of the payments and unguaranteed residual value at the implicit rate.
3Compute the gross investment: total lease payments plus any unguaranteed residual value. Unearned finance income = gross investment − net investment.
4Pass the inception entry. Debit Lease receivable (gross, or net if the question uses net) and credit the asset, plus Unearned finance income if you use the gross method.
5Build the schedule year by year: opening net investment, finance income at the implicit rate, payment received, closing net investment.
6Pass the periodic entries: Bank Dr, Lease receivable Cr for the payment received; Unearned finance income Dr, Finance income Cr for the income of the year.
7Check that closing net investment at the end equals the unguaranteed residual value (or zero if none) and that total finance income equals unearned finance income at inception.
8Show the balance sheet extract if asked: net investment (receivable) split into amount due within one year and later, and note the disclosures.

Quickest way: Schedule-first method

When to use it: Use it when the question asks for finance income of a given year, the lease receivable at a date, or journal entries for several years.

Write the net investment and the rate at the top of your page.
Make four columns in a rough grid: opening, income, payment, closing. Fill the first row only if you need year 1.
Finance income = opening × rate. Closing = opening + income − payment. Repeat.
Make the last year a balancing figure. Round income so closing becomes exactly zero or equals the residual value.
For MCQs, remember: income falls each year, receivable falls every year, and the first-year income is the largest.

Common mistakes in Accounting for Finance Leases in Books of Lessor

Showing the receivable at gross investment (total of payments) instead of net investment on the balance sheet.
Students add up the instalments and stop. They forget the unearned finance income that is deducted.
Fix: Receivable = gross investment − unearned finance income (para 3.16 and 26). If you debit gross at inception, always credit Unearned finance income for the difference.
Treating the whole lease payment as income.
It feels like rent, as in an operating lease.
Fix: Under a finance lease each payment is principal repayment plus finance income (para 27). Only the finance income part goes to the profit and loss account.
Charging depreciation on the leased asset in the lessor's books.
Students keep the asset in the lessor's books out of habit from operating leases.
Fix: The lessor derecognises the asset and recognises a receivable. Depreciation belongs to the lessee.
Spreading finance income equally (straight line) over the years.
Equal division is quicker than a schedule.
Fix: Income must give a constant periodic rate on the outstanding net investment (para 28, 29). It is highest in year 1 and falls.
Using the cost price as the net investment for a dealer lessor and ignoring the selling profit.
Students forget that a dealer has two sources of income.
Fix: For a manufacturer or dealer lessor, recognise the profit on sale at normal selling price at inception, plus finance income over the term (para 33). Receivable is based on the selling price (or lower present value), not cost.
Increasing the unguaranteed residual value when it turns out higher than estimated.
Students assume revaluation upward is allowed as in other areas.
Fix: Para 30 permits only a reduction. Revise the income allocation and recognise the reduction in amounts already accrued immediately. No upward adjustment is made.

Worked examples

Example 1

Mahadev Finance Ltd. leases a machine to Ravi Textiles Ltd. on 1 April 2026. The machine costs and has a fair value of ₹10,00,000. The lease is a finance lease for 3 years. Ravi Textiles pays ₹4,02,115 at the end of each year. The rate implicit in the lease is 10% and there is no residual value. Prepare the schedule of finance income and pass journal entries in the books of the lessor for the inception and for year 1.

Show the solution

Net investment at inception = ₹10,00,000 (the present value of the payments at 10% equals the fair value).
Gross investment = 3 × ₹4,02,115 = ₹12,06,345. Unearned finance income = ₹12,06,345 − ₹10,00,000 = ₹2,06,345.
Year 1: opening ₹10,00,000; finance income at 10% = ₹1,00,000; payment ₹4,02,115; closing = 10,00,000 + 1,00,000 − 4,02,115 = ₹6,97,885.
Year 2: opening ₹6,97,885; finance income = ₹69,789 (rounded); payment ₹4,02,115; closing = 6,97,885 + 69,789 − 4,02,115 = ₹3,65,559.
Year 3: opening ₹3,65,559; finance income = ₹36,556 (rounded); payment ₹4,02,115; closing = 3,65,559 + 36,556 − 4,02,115 = ₹0.
Check: total finance income = 1,00,000 + 69,789 + 36,556 = ₹2,06,345, equal to the unearned finance income at inception.
Inception entry: Lease receivable (Ravi Textiles Ltd.) A/c Dr ₹12,06,345; to Machinery A/c ₹10,00,000; to Unearned finance income A/c ₹2,06,345.
End of year 1, receipt: Bank A/c Dr ₹4,02,115; to Lease receivable A/c ₹4,02,115.
End of year 1, income: Unearned finance income A/c Dr ₹1,00,000; to Finance income A/c ₹1,00,000.
Net investment at end of year 1 = receivable ₹8,04,230 − unearned finance income ₹1,06,345 = ₹6,97,885, which agrees with the schedule.

Answer: Finance income: year 1 ₹1,00,000, year 2 ₹69,789, year 3 ₹36,556 (total ₹2,06,345). Net investment at the end of year 1 is ₹6,97,885. Entries are as shown above.

Example 2

Kaveri Motors Ltd., a dealer, leases a vehicle with a cost of ₹8,00,000 and a normal selling price of ₹10,00,000 under a 3-year finance lease. The lessee pays ₹4,02,115 at each year end. The rate implicit in the lease is 10% and the present value of the payments at that rate is ₹10,00,000. Compute the profit recognised at inception, the finance income for year 1 and the net investment at the end of year 1. Pass the inception entries.

Show the solution

Because the lessor is a dealer, the lease gives two kinds of income (para 33): profit like an outright sale, and finance income over the lease term.
Net investment at inception = ₹10,00,000 (present value of payments at the implicit rate, equal to the normal selling price).
Profit at inception = selling price ₹10,00,000 − cost ₹8,00,000 = ₹2,00,000. It is recognised at inception.
Inception entries: Lease receivable A/c Dr ₹10,00,000; to Sales A/c ₹10,00,000. Cost of goods sold A/c Dr ₹8,00,000; to Inventory (Vehicle) A/c ₹8,00,000.
Finance income for year 1 = ₹10,00,000 × 10% = ₹1,00,000.
Net investment at end of year 1 = 10,00,000 + 1,00,000 − 4,02,115 = ₹6,97,885.
Year 1 entries: Bank A/c Dr ₹4,02,115; to Lease receivable A/c ₹4,02,115. Lease receivable A/c Dr ₹1,00,000; to Finance income A/c ₹1,00,000.

Answer: Profit at inception ₹2,00,000; finance income for year 1 ₹1,00,000; net investment at the end of year 1 ₹6,97,885.

Exam tips

Write the net investment and unearned finance income first. Examiners award step marks for these two figures even if later arithmetic slips.
Always show the schedule with four columns. Marks are given for the layout and for each year's income.
In theory questions, quote the idea in your own words: constant periodic rate of return on net investment, with payments reducing both principal and unearned finance income.
If the question mentions a unguaranteed residual value, include it in gross investment and remember it is not collected as a payment. Only reductions in its estimate are recognised (para 30).
For disclosure questions, list the reconciliation of gross investment with present value of minimum lease payments receivable, unearned finance income, unguaranteed residual values, provision for uncollectible payments, contingent rents, a description of leasing arrangements and the policy on initial direct costs (para 37). Small and medium entities have some relief from the reconciliation and description disclosures.

Practice questions from Lease Accounting

Accounting for Finance Leases in Books of Lessor in other exams

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

Accounting for Finance Leases in Books of Lessor: frequently asked questions

What does the lessor record at the start of a finance lease?

The lessor removes the asset from its books and records a lease receivable equal to the net investment in the lease (para 26). If you use the gross method, you credit Unearned finance income for the difference between gross and net investment. For a dealer, the sale profit is also recognised at this point.

How is finance income calculated each year?

Multiply the opening net investment by the implicit rate. AS 19 requires a constant periodic rate of return on the net investment outstanding (para 28 and 29). Income therefore falls every year as the net investment is repaid.

What is the difference between gross investment and net investment?

Gross investment is the minimum lease payments receivable plus any unguaranteed residual value for the lessor. Net investment is the gross investment less unearned finance income (para 3.16). The net figure is what appears as the receivable.

Does the lessor charge depreciation in a finance lease?

No. The lessor treats the asset as sold on credit and shows a receivable instead. Depreciation is charged only by the party that records the asset, which is the lessee in a finance lease.

Is there negative marking in the MCQs on lease accounting?

No. Neither the question papers nor the ICMAI prospectus provide for negative marking, so attempt every MCQ.