Sales Type Lease accounting by the lessor involves recognizing revenue from leases when specific criteria are met. This process requires a thorough understanding of the Financial Accounting Standards Board (FASB) guidelines and International Financial Reporting Standards (IFRS), which dictate the treatment of leases in financial statements.
Key Criteria for Sales Type Leases
To classify a lease as a Sales Type Lease, the following two sets of criteria must be satisfied:
Capital Lease Criteria
The lease must meet one or more of the following conditions:
- Transfer of Ownership: The lease transfers ownership of the property to the lessee by the end of the lease term.
- Bargain Purchase Option: The lease contains an option for the lessee to purchase the property at a bargain price.
- Lease Term: The term of the lease is greater than or equal to 75% of the economic life of the leased property.
- Present Value: The present value of the minimum lease payments amounts to at least 90% of the fair value of the leased property.
Additional Criteria for Sales Type Lease
In addition to meeting one or more of the capital lease criteria, the following must also be true:
- Collectibility of Minimum Lease Payments: The lessor can predictably collect the minimum lease payments.
- No Important Uncertainties: There are no significant uncertainties regarding the amount of unreimbursable costs yet to be incurred by the lessor.
Accounting Treatment for Sales Type Lease
Initial Recognition
When a lease is classified as a sales type lease:
- Asset Derecognition: The lessor removes the leased asset from its balance sheet.
- Net Investment in Lease: The lessor recognizes a ‘Net Investment in Lease,’ which is the present value of the lease payments plus the present value of any unguaranteed residual value.
Income Recognition
- Sales Revenue: Recognize sales revenue equivalent to the present value of lease payments.
- Cost of Goods Sold (COGS): Recognize the cost of the asset as COGS.
Subsequent Measurement
- Interest Income: The lessor will recognize interest income over the lease term, based on a pattern that reflects a constant periodic rate of return on the lessor’s net investment in the lease.
Example Scenario
Consider a lessor who leases machinery worth $100,000 on a five-year lease term. The lessee has a bargain purchase option. The machinery’s economic life is 7 years, and the present value of the lease payments approximates to $95,000.
Given the above:
- The lease meets the capital lease criteria (bargain purchase option).
- Minimum lease payments’ collectibility is predictable.
- There are no significant uncertainties regarding unreimbursable costs.
The lessor recognizes:
- Initial Sales Revenue: $95,000
- COGS: The historical cost of the machinery
- Net Investment in Lease: Present value of the lease payments
Historical Context
Sales type lease accounting gained prominence with the introduction of guidelines by the FASB in the 1970s. These guidelines were refined over decades, notably with ASC 842, which modernized lease accounting to ensure transparency in financial reporting.
Applicability and Use Cases
Sales type leases are particularly significant in industries with high-value equipment leases, such as aviation, manufacturing, and technology. These leases provide lessors with immediate revenue recognition, thus impacting profitability metrics.
Comparison with Direct Financing Leases
Unlike sales type leases, direct financing leases do not result in immediate profit recognition. Instead, they generate income through the interest revenue over the lease term.
Related Terms
- Direct Financing Lease: A lease where the present value of lease payments equals the carrying amount of the leased asset.
- Operating Lease: A lease that does not meet the criteria for capitalization and is treated as rental.
- Net Investment in Lease: The net amount a lessor expects to receive from lease payments and unguaranteed residual value.
- Unguranteed Residual Value: An estimated amount receivable at the end of the lease term that is not guaranteed by the lessee or any third party.
Frequently Asked Questions
What is a Sales Type Lease?
A Sales Type Lease is a lease where the lessor recognizes immediate profit from the sale of the leased asset, alongside interest income over the lease term.
How does Sales Type Lease impact financial statements?
It affects several sections, including the removal of the asset, the recognition of sales revenue and COGS, and the creation of net investment in lease.
Are there any significant changes with the introduction of ASC 842?
Yes, ASC 842 mandates detailed disclosures regarding lease transactions, enhancing transparency and comparability across financial statements.
References
- Financial Accounting Standards Board (FASB). “Leases (Topic 842).” FASB.
- International Financial Reporting Standards (IFRS 16).
- Ernst & Young. “A Closer Look at Lease Accounting under ASC 842.”
Summary
Sales type lease accounting by the lessor is a complex yet crucial aspect of lease transactions. It involves criteria related to capital leases and specific conditions about payment collectibility and expense certainty. The proper classification and accounting treatment not only ensure compliance but also reflect the financial health and profitability of entities engaged in leasing activities.
