Final answer:
Unearned income in a direct-financing lease by the lessor should be amortized using the effective interest method, which aligns the recognition of finance income with the reduction of the lessor's net investment in the lease.
Step-by-step explanation:
In a lease that is categorized as a direct-financing lease by the lessor, unearned income should be amortized over the period of the lease using the effective interest method. This approach aligns the recognition of finance income with the reduction of the net investment in the lease, reflecting the periodic interest income earned by the lessor. This method of amortization results in a decreasing lease receivable balance and a corresponding gradual recognition of income over the lease term, which typically mirrors the pattern of the decline in the lessor's economic interest in the leased asset.
It's important to distinguish this from the straight-line method, which would evenly distribute income over the lease term regardless of the pattern of the decline in the residual investment of the leased asset, and typically is not used in the context of a direct-financing lease by the lessor. In a direct-financing lease, unearned income should be amortized over the period of the lease using the effective interest method. This method allocates the interest expense over time based on the prevailing interest rate and the remaining balance of the lease receivable. It reflects the time value of money and provides a more accurate representation of the income earned by the lessor.