SFAS 91, issued in December 1986, narrowed the definition of initial direct costs and amended the reporting requirements of SFAS 13 concerning initial direct costs incurred by lessors in direct financing leases. The effect of the amended reporting requirements was cosmetic. The pronouncement replaces the dual entry approach, which initially charged direct costs to expense and then reclassified them as an asset, with direct capitalization of initial direct costs as part of the gross investment in the lease.

In order to effect these changes, SFAS 91 provided wording to supersede or amend two paragraphs of SFAS 13. Unfortunately, the new wording in one key paragraph did not properly detail the effect of initial direct costs on the gross investment in the lease. Because of this wording, difficulties arose in recording direct financing leases when the lessor incurred initial direct costs. Accordingly, SFAS 98 was issued in May 1988, to re-amend the wording to reflect the FASB's original intent in issuing SFAS 91.

This article demonstrates the wording in SFAS 98 is still unclear regarding the proper treatment of initial direct costs. The example in this article illustrates that the ambiguity in SFAS 13, SFAS 91, and SFAS 98 stems from confusion about how the lessor determines annual lease payments. The solution to the basic finance problem of determining annual lease payments provides a useful guide to the lessor recording a direct financing lease. We provide an alternative wording which better reflects the intent of the FASB regarding initial direct costs in direct financing leases.

SFAS 13, SFAS 91, SFAS 98--A

Comparison

Paragraphs 18 (a) and 18 (b) of SFAS 13 defined two terms which were subsequently revised by SFAS 91 and SFAS 98. These terms are "gross investment in the lease" and "net investment in the lease." SFAS 91 explicitly included initial direct costs as a separate component of the gross investment in the lease, while SFAS 98 excludes initial direct costs as an explicit component of the gross investment.

Clearly, the FASB's intent in all three standards is to capitalize initial direct costs as part of the total cost of the asset being leased. However, the wording used in the three standards is both inexact and confusing, due in large part to the FASB's difficulty in recognizing that a lessor computes minimum lease payments so that all invested funds, including initial direct costs, will be recovered. As such, the first component of the gross investment in the lease in all three standards, the minimum lease payments, already includes initial direct costs.

SFAS 91 tried to recognize initial direct costs as part of the gross investment. However, by doing so, initial direct costs are double counted because the lease payments as computed by the lessor include recovery of these costs. In this situation, the net investment in the lease is correctly stated, but both the gross investment in the lease and unearned revenue are overstated due to double counting the initial direct costs.

To avoid the double counting problem, SFAS 98 properly drops initial direct costs as a separate component of the gross investment, but runs into difficulty in its new definition of the net investment in the lease. The net investment in the lease implicitly includes initial direct costs in the minimum lease payment component plus initial direct costs, less unearned revenue. In amending SFAS 91, the FASB merely transferred the double counting problem from one paragraph to another. Also, no guidance is provided on what account should be debited to offset the credit to cash for the initial direct costs. The example below demonstrates these problems.

An Example

The lessor's problem of determining annual lease payments in a direct financing lease where the lessor has incurred direct costs may be illustrated using the following fact situation:

The Lessor's company enters into a lease on December 31, 1986, which is properly accounted for as a direct financing lease:

1. The term of the lease is three years and payments are due at the end of each year;

2. The cost of the asset being leased is $124,343 with no residual value at the end of the lease term;

3. The lease requires a return of 10 percent on invested funds;

4. The Lessor company incurs $7,500 of direct costs at the inception of the lease.

Before encountering any accounting problems involved with recording the lease transaction, the lessor first determines the amount of the annual lease payments as $53,016 ($124,343 + $7,500) + P/V factor 2.48685. The lessor requires a return on all invested funds, including initial direct costs. Exhibit 1 compares the journal entries which would be made by strict application of each of the three standards.

The first column (SFAS 13) demonstrates the dual entry approach for initial direct costs. By expensing initial direct costs as incurred and then recognizing an equal amount of income, the end effect is to capitalize initial direct costs as part of the gross investment in the lease. Note that the gross investment in the lease ($159,048) less the unearned income of $27,205 ($34,705 - $7,500) yields the total cost of the leased property ($131,843). The total cost should always equal the net investment in the lease, as it does in the SFAS 13 case.

SFAS 91 explicitly includes initial direct costs as a separate component of the gross investment. Note in Exhibit 1 that strict application of this standard results in double counting the initial direct costs as part of the gross investment. Moreover, the first journal entry capitalizes these costs in undiscounted future dollars of $9,048 ($3,016 x 3), and the second journal entry capitalizes these costs in present value dollars of $7,500. While the above errors yield the correct net investment in the lease of $131,843, both the gross investment and unearned revenue are overstated by the amount of the initial direct costs.

SFAS 98 reverted to the original definition of the gross investment in the lease in SFAS 13, but revised the definition of the net investment. While the gross investment in the lease is now correctly recorded at $159,048, there is ambiguity concerning how much unearned revenue is to be recorded. If the debit in journal entry (2) in Exhibit 1 is to unearned revenue, then that account will have a correct balance of $27,205, but the net investment in the lease will be incorrectly stated at $139,343 ($159,048 plus the initial direct costs of $7,500 less the unearned revenue of $27,205). Conversely, if the debit is to initial direct costs, then net investment in the lease will be correctly recorded at $131,843; but the initial direct costs will have been capitalized twice, once in lease payments receivable and once in initial direct costs.

Based on this example, it is apparent that the SFAS 98 still falls short in its attempt to provide clear procedures for lessors who incur initial direct costs in direct financing leases.

A Suggested Amendment to SFAS 13

By combining the three single entries for SFAS 13 in Exhibit 1 into one compound entry, the economic substance of the transaction is demonstrated in Exhibit 2.

One suggestion the FASB might consider to clarify the issue would be to define gross investment as:

Sum of (i) the minimum lease payments (net amounts, if any, included therein with respect to executory costs and paid by the lessor, together with any profit thereon), (ii) the unguaranteed residual value accruing to the benefit of the lessor, and (iii) the portion of the minimum lease payments representing a recovery of initial direct costs.