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The amortization of a leased asset is determined by the asset's historical cost, expected economic life, residual value, and the amortization method. Most finance leases are amortized with continuous payments over the term of the lease and are customized to meet the specific needs of the lessee.

It is a capital lease to the lessee since the lease term exceeds 75% of the asset's economic life and the present value of the minimum lease payments exceeds 90% of the asset's fair value. The lease is a direct financing lease to the lessor if rent collectability is substantially ensured and no significant uncertainty surrounds the number of unreimbursable expenditures yet to be spent by the lessor.

The lessee should use the capital lease method and record the leased asset and lease liability at the present value of the minimum lease payments based on the lessee's incremental borrowing rate or the interest rate implicit in the lease if it is lower than the incremental rate and known to the lessee.

The lessee's depreciation is determined by whether ownership is transferred to the leased or if a bargain buy option is available. If one of these requirements is met, amortization will occur over the asset's economic life. Otherwise, it would be depreciated throughout the length of the lease. Because the asset's economic life and lease term are both three years, the leased asset should be depreciated during this time period.

The lessor should use the direct-financing lease method and replace the $95,000 asset cost with a Lease Receivable of $95,000. (see the schedule below.) Annual interest would be paid at a constant rate relative to the unrecovered net investment.

Working Notes:-

$$\begin{gathered} \mathrm{Three}\mathrm{annual}\mathrm{lease}\mathrm{payments}=\frac{\mathrm{cost}\mathrm{and}\mathrm{fair}\mathrm{value}}{\mathrm{present}\mathrm{value}\mathrm{of}\mathrm{ordinary}\mathrm{annuity}} \\ =\frac{\$95,000}{2.53130} \\ =\$37,530 \end{gathered}$$

Note: Present value of an ordinary annuity of 1 for 3 periods at 9%