CHAPTER THREE

LEASES

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Learning Objectives
1. Explain the nature, economic substance, and advantages of lease
transactions.
2. Describe the accounting criteria and procedures for capitalizing leases
by the lessee.
3. Contrast the operating and capitalization methods of recording leases.
4. Describe the lessee’s accounting for finance lease
5. Describe the lessee’s accounting for operating lease
6. Identify the classifications of leases for the lessor.
7. Describe the lessor’s accounting for direct-financing leases.
8. Describe the lessor’s accounting for operating lease
9. Describe the lessor’s accounting for sales-type leases.

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The Leasing Environment
A lease is a contractual agreement between a lessor and a lessee.
This arrangement gives the lessee the right to use specific property,
owned by the lessor, for an agreed period of time.
In return for the use of the property, the lessee makes rental payments
over the lease term to the lessor.
Generally, a lease is a contractual agreement between a lessor and a
lessee, that gives the lessee the right to use specific property, owned by
the lessor, for a specified period of time.
Largest group of leased equipment involves:
 Information technology
 Transportation (trucks, aircraft, rail)
 Construction
 Agriculture

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…The Leasing Environment
Who are the lessors that own this property? They generally fall
into one of three categories:
1. Banks.
Banks are the largest players in the leasing business.
They have low-cost funds, which give them the advantage of
being able to purchase assets at less cost than their competitors.
2. Captive leasing companies.
Captive leasing companies are subsidiaries whose primary
business is to perform leasing operations for the parent
company
Captive leasing companies have the point-of-sale advantage in
finding leasing customers
3. Independents.

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…The Leasing Environment
Advantages of Leasing
1. 100% financing at fixed rates. Leases are often signed
without requiring any money down payment.
 This helps the lessee conserve scarce cash.
 In addition, lease payments often remain fixed, which
protects the lessee against inflation and increases in the cost
of money.
2. Protection against obsolescence. Leasing equipment reduces
risk of obsolescence to the lessor, and in many cases passes the
risk of residual value to the lessee.
3. Flexibility. Lease agreements may contain less restrictive
provisions than other debt agreements.
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…The Leasing Environment

4. Less costly financing. Leasing cheaper than other forms of

financing.
5. Tax advantages. companies can capitalize and depreciate the
leased asset.
 As a result, a company takes deduction & reduces taxes.
6.Off-balance-sheet financing. Operating lease protect
Companies from adding debt in their financial statement.
 So that this type leases do not add debt on a statement of
financial position or affect financial ratios.

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…The Leasing Environment
 Conceptual Nature of a Lease
Capitalize a lease that transfers substantially all of the benefits
and risks of property ownership, provided the lease is non
cancelable.
Leases that do not transfer substantially all the benefits and risks
of ownership are operating leases.
 Accounting treatment for operating lease
Rent Expense XXX
Cash XXX
 Accounting treatment for Capital lease
Leased Equipment XXX
Lease Liability XXX
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Accounting by the Lessee – Finance Lease
If the lessee capitalizes a lease, the lessee records an asset and
a liability generally equal to the present value of the rental
payments.
 Records depreciation on the leased asset.
 Treats the lease payments as consisting of interest and
principal.
Journal Entries for Capitalized Lease

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…Accounting by the Lessee – Finance Lease
For a Finance lease, the IASB has identified four criteria.

1. Lease transfers ownership of the property to the lessee.

2. Lease contains a bargain-purchase option.
3. Lease term is for major part of the economic life of the asset.
4. Present value of the minimum lease payments amounts to
substantially all of the fair value of the leased asset
Notice; One or more criteria must be met for finance lease
accounting .
Leases that DO NOT meet any of the four criteria are
accounted for as Operating Leases.

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…Accounting by the Lessee – Finance Lease

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…Accounting by the Lessee – Finance Lease
Capitalization criteria
1. Transfer of Ownership Test
If the lease transfers ownership of the asset to the lessee, it is a
finance lease.
2. Bargain-Purchase Option Test
A bargain-purchase option allows the lessee to purchase the leased
property for a price that is significantly lower than the property’s
expected fair value at the date the option becomes exercisable.
At the inception of the lease, the difference between the option
price and the expected fair value must be large enough to make
exercise of the option reasonably assured.

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…Accounting by the Lessee – Finance Lease
3. Economic Life Test
If the lease period is for a major part of the asset’s economic
life, the lessor transfers most of the risks and rewards of
ownership to the lessee.
Capitalization is therefore appropriate.
The IASB has not defined what is meant by the “major part” of
an asset’s economic life.
In practice, following the IASB hierarchy, it has been
customary to look to U.S. GAAP, which has a 75 percent of
economic life threshold for evaluating the economic life test.

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…Accounting by the Lessee – Finance Lease
4. Recovery of Investment Test
If the present value of the minimum lease payments equals or
exceeds substantially all of the fair value of the asset, then a
lessee should capitalize the leased asset. Why?
If the present value of the minimum lease payments is
reasonably close to the fair value of the asset , the lessee is
effectively purchasing the asset.
As with the economic life test, the IASB has not defined what
is meant by “substantially all” of an asset’s fair value.
In practice, it has been customary to look to U.S. GAAP, which
has a 90 percent of fair value threshold for assessing the
recovery of investment test.

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…Accounting by the Lessee – Finance Lease
Determining the present value of the minimum lease payments
involves three important concepts: (1) minimum lease
payments, (2) executory costs, and (3) discount rate.
1. Minimum lease payments
 the amount that the lessee is obligated to pay which includes;
a) periodic lease rental payment
b) any guarantee by lessee for residual value
c) price agreed under purchase option
d) any penalty due to non renewal of lease

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…Accounting by the Lessee – Finance Lease
a) Periodic rental payment
 It is a rental payment which made regularly by the lessee
b) Guaranteed residual value
 The residual value is the estimated fair value of the leased property at the
end of the lease term.
The guaranteed residual value is either
 a certain amount that the lessee will pay the lessor at the end of the lease to
purchase the leased property, or
 the amount the lessee guarantees that the lessor will realize if the leased
asset is returned.
c) Bargain-purchase option
 It is an option given to the lessee to purchase the leased asset at the end of
the lease term at a price that is fixed sufficiently below the expected fair
value.
d) Penalty for failure to renew or extend the lease
 The amount the lessee must pay if the agreement specifies that it must
extend or renew the lease, and it fails to do so.
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…Accounting by the Lessee – Finance Lease
2.Executory Costs.
 Like most assets, leased tangible assets incur insurance,
maintenance, and tax expenses—called executory costs—during
their economic life.
If the lessee retains responsibility for the payment of these
“ownership-type costs,” it should exclude, in computing the
present value of the minimum lease payments.
Executory costs do not represent payment on or reduction of the
obligation.

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…Accounting by the Lessee – Finance Lease
3. Discount Rate.
A lessee, computes the present value of the minimum lease payments
using the implicit interest rate.
Implicit rate ; is the discount rate that causes the aggregate present
value of the minimum lease payments and the unguaranteed residual
value to be equal to the fair value of the leased asset
In the event that it is impracticable to determine the implicit rate, the
lessee should use its incremental borrowing rate.
The incremental borrowing rate; is the rate of interest the lessee
would have to pay on a similar lease or the rate that, at the inception
of the lease, the lessee would incur to borrow funds necessary to
purchase the asset.
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…Accounting by the Lessee – Finance Lease
 Asset recognition & incurrence of a liability
 Under the finance lease method, the lessee treats the lease
transaction as if it purchases the property in a financing
transaction.
 That is, the lessee acquires the asset and creates an obligation.
 Therefore, it records a finance lease as an asset and a liability at
the lower of
(1) the present value of the minimum lease payments (excluding
executory costs) or
(2) the fair value of the leased asset at the inception of the lease.
The rationale for this approach is that companies should not
record a leased asset for more than its fair value.

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…Accounting by the Lessee – Finance Lease
 Depreciation Period
One troublesome aspect of accounting for the depreciation of
the capitalized leased asset relates to the period of depreciation.
 If the lease agreement transfers ownership of the asset to lessee
(criterion 1) or contains a bargain-purchase option (criterion 2),
the depreciates the asset using the economic life of the asset.
On the other hand, if the lease does not transfer ownership or
does not contain a bargain-purchase option, then the lessee
depreciates it over the term of the lease.

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…Accounting by the Lessee – Finance Lease
 Effective-Interest Method
Throughout the term of the lease, the lessee uses the effective-
interest method to allocate each lease payment between
principal and interest.
This method produces a periodic interest expense equal to a
constant percentage of the carrying value of the lease
obligation.
When applying the effective-interest method to finance leases,
the lessee must use the same discount rate that determines the
present value of the minimum lease payments.

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…Accounting by the Lessee – Finance Lease
Depreciation Concept
Although the lessee computes the amounts initially capitalized
as an asset and recorded as an obligation at the same present
value, the depreciation of the asset and the discharge of the
obligation are independent accounting processes during the
term of the lease.
It should depreciate the leased asset by applying conventional
depreciation methods: straight-line, sum-of-the-years’ digits,
declining-balance, units of production, etc.

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…Accounting by the Lessee – Finance Lease
 Illustration; assume that Caterpillar Corp. and Sterling Construction
Corp. sign a lease agreement dated January 1, 2012, that calls for
Caterpillar to lease a front-end loader to Sterling beginning January 1,
2012. The terms and provisions of the lease agreement, and other
pertinent data, are as follows.
1. The term of the lease is five years. The lease agreement is non-
cancelable, requiring equal rental payments of $25,981.62 at the
beginning of each year (annuity-due basis).
2. The loader has a fair value at the inception of the lease of $100,000, an
estimated economic life of five years, and no residual value.
3. Sterling pays all of the executory costs directly to third parties except
for the property taxes of $2,000 per year, which is included as part of its
annual payments to Caterpillar.
4. The lease contains no renewal options. The loader reverts to
Caterpillar at the termination of the lease.
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…Accounting by the Lessee – Finance Lease
5. Sterling’s incremental borrowing rate is 11 percent per year.
6. Sterling depreciates similar equipment that it owns on a straight-line basis.
7. Caterpillar sets the annual rental to earn a rate of return on its investment of
10 percent per year; Sterling knows this fact.
Instructions
(a) What type of lease is this? Explain.
(b) Compute the present value of the minimum lease payments.
(c) Prepare all necessary journal entries for Sterling for this lease through
January 1, 2012.
Solutions ;
 The lease meets the criteria for classification as a capital lease for the
following reasons.
1. The lease term of five years, being equal to the equipment’s estimated
economic life of five years, satisfies the economic life test.
2. The present value of the minimum lease payments ($100,000 as computed
below) equals the fair value of the loader ($100,000).
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…Accounting by the Lessee – Finance Lease
The minimum lease payments = $23,981.62 x 5= $119,908.10.
Sterling computes the amount capitalized as leased assets as
the present value of the minimum lease payments (excluding
executory costs – property taxes of $2,000) as follows:
Capitalized amount = ($25,981.62 – $2,000) x Present value of
an annuity due of 1 for 5 periods at 10%
= $23,981.62 x 4.16987
= $100,000
Sterling uses Caterpillar Corp’s implicit interest rate of 10
percent instead of its incremental borrowing rate of 11 percent
because it knows about it. Sterling records the finance lease
on its books on January 1, 2015, as follows;
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…Accounting by the Lessee – Finance Lease
Jan 1,2012 Leased Equipment 100,000
Lease Liability 100,000
Note that the entry records the obligation at the net amount of $100,000 (the
present value of the future rental payments) rather than at the gross amount
of $119,908.10 ($23,981.62 x 5).
 Sterling records the first lease payment on January 1, 2012, as
follows.
Jan 1,2012 Property tax Expense 2,000.00
Lease liability 23,981.62
Cash 25,981.62

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…Accounting by the Lessee – Finance Lease
Each lease payment of $25,981.62 consists of three elements:
 a reduction in the lease liability,
 a financing cost (interest expense), and
 executory costs (property taxes).
The total financing cost (interest expense) over the term of the
lease is $19,908.10.
This amount is the difference between the present value of the
lease payments ($100,000) and the actual cash disbursed, net
of executory costs ($119,908.10).
Therefore, the annual interest expense, applying the effective-
interest method, is a function of the outstanding liability, as the
following schedule shows
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…Accounting by the Lessee – Finance Lease

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…Accounting by the Lessee – Finance Lease
 At the end of its fiscal year, December 31, 2012, Sterling
records accrued interest as follows
Dec 31,2012 Interest expense 7,601.84
Interest payable 7,601.84
 Depreciation of the leased equipment over its five-year lease
term, applying Sterling’s normal depreciation policy (straight-
line method), results in the following entry on December 31,
2012.
Dec 31,2012 Depreciation expense 20,000
Accumulated depreciation 20,000
(100,000 / 5 years)

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…Accounting by the Lessee – Finance Lease
 At December 31, 2012, Sterling separately identifies the assets recorded
under finance leases on its statement of Financial position.
 Similarly, it separately identifies the related obligations. Sterling
classifies the portion due within one year or the operating cycle,
whichever is longer, with current liabilities, and the rest with noncurrent
liabilities.
 For example, the current portion of the December 31, 2012, total
obligation of $76,018.38 in Sterling’s amortization schedule is the
amount of the reduction in the obligation in 2013, or $16,379.78.
 The following presentation shows the liabilities section as it relates to
lease transactions at December 31, 2012.
Current liabilities
Interest payable $ 7,601.84
Lease liability 16,379.78
Noncurrent liabilities
Lease liability $59,638.60
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…Accounting by the Lessee – Finance Lease
Sterling records the lease payment of January 1, 2013, as follows.
Jan 1,2013 Property tax expense 2,000.00
Interest payable 7,601.84
Lease Liability 16,379.78
Cash 25,981.82
Entries through 2016 would follow the pattern above. Sterling records its
other executory costs (insurance and maintenance) in a manner similar to
how it records any other operating costs incurred on assets it owns.
Upon expiration of the lease, Sterling has fully amortized the amount
capitalized as leased equipment. It also has fully discharged its lease
obligation. If Sterling does not purchase the loader, it returns the
equipment to Caterpillar. Sterling then removes the leased equipment and
related accumulated depreciation accounts from its books.

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…Accounting by the Lessee – Finance Lease
If Sterling purchases the equipment at termination of the lease,
at a price of $5,000 and the estimated life of the equipment
changes from five to seven years, it makes the following entry.
Jan 1,2016 Equipment (100,000+5000) 105,000
Acc. Dep. Leased Equipment 100,000
Leased Equipment 100,000
Acc. Dep. Equipment 100,000
Cash 5,000

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Accounting by the Lessee – Operating Lease
Under the operating method, rent expense (and the associated
liability) accrues day by day to the lessee as it uses the property.
The lessee assigns rent to the periods benefiting from the use of
the asset and ignores, in the accounting, any commitments to
make future payments.
The lessee makes appropriate accruals or deferrals if the
accounting period ends between cash payment dates.
For example, assume that the capital lease illustrated in the
previous section did not qualify as a capital lease.
Sterling therefore accounts for it as an operating lease. The first-
year charge to operations is now $25,981.62, the amount of the
rental payment.

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…Accounting by the Lessee – Operating Lease
 Sterling records this payment on January 1, 2012, as follows.
Jan 1, 2012 Rent expense 25,981.62
Cash 25,981.62
 Sterling does not report the asset, as well as any long-term
liability for future rental payments, on the its statement of
Financial Position.
 Sterling reports rent expense on the income statement.
 Sterling must disclose all operating leases that have non-
cancelable lease terms in excess of one year.

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…Accounting by the Lessee – Operating Lease
Comparison of Finance Lease with Operating Lease
If accounting for the lease as an operating lease, the first-year
charge to operations is $25,981.62, the amount of the rental
payment.
Treating the transaction as a Finance lease, however, results in a
first-year charge of $29,601.84: depreciation of $20,000 (assuming
straight-line), interest expense of $7,601.84, and executory costs of
$2,000.
The following schedule shows that while the total charges to
operations are the same over the lease term whether accounting for
the lease as a Finance lease or as an operating lease.
Under the finance lease treatment the charges are higher in the
earlier years and lower in the later years.
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…Accounting by the Lessee – Operating Lease

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…Accounting by the Lessee – Operating Lease
Therefore, the following differences occur if using a capital
lease instead of an operating lease.
 An increase in the amount of reported debt (both short-term
and long-term).
 An increase in the amount of total assets (specifically long-
lived assets).
 A lower income early in the life of the lease and, therefore,
lower retained earnings.

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Accounting by Lessor
Three important benefits are available to the lessor:
Interest revenue – Leasing is a form of financing. Banks,
captives, and independent leasing companies find leasing
attractive because it provides competitive interest margins.
Tax incentives – In many cases, companies that lease
cannot use the tax benefit of the asset, but leasing allows
them to transfer such tax benefits to another party (the
lessor) in return for a lower rental rate on the leased asset.
High residual value – Another advantage to the lessor is
the return of the property at the end of the lease term.
Residual values can produce very large profits.

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Accounting by Lessor
Economics of Leasing
A lessor determines the amount of the rental, basing it on
the rate of return – the implicit rate – needed to justify
leasing.
In establishing the rate of return, lessor considers the
credit standing of lessee, the length of the lease, and the
status of the residual value (guaranteed versus
unguaranteed).
In the earlier example, Caterpillar’s implicit rate was 10%,
the cost of the equipment to Caterpillar was $100,000
(also fair value), and the estimated residual value was
zero.
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…Accounting by Lessor
Caterpillar determines the amount of the lease payment as
follows
Fair value of leased equipment $100,000.00
Less: Present value of the residual value 0.00
Amount to be recovered by lessor through
lease payments $100,000.00
Five beginning-of-the-year lease payments
to yield a 10% return ($100,000 ÷ 4.16987a)
$23,981.62
  a
PV of an annuity due of 1 for 5 years at 10%
 
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…Accounting by Lessor
Classification of Leases by the Lessor
For accounting purposes, the lessor also classifies leases as operating or
finance leases.
Finance leases may be further subdivided into direct-financing and sales-
type leases.
As with lessee accounting, if the lease transfers substantially all the risks
and rewards incidental to ownership, the lessor shall classify and account
for the arrangement as a finance lease..
The distinction for the lessor between a direct-financing lease and a sales-
type lease is the presence or absence of a manufacturer’s or dealer’s profit
(or loss).
 A sales type lease involves a manufacturer's or dealer's profit, and a direct-
financing lease does not.
The profit (or loss) to the lessor is evidenced by the difference between the
fair value of the leased property at the inception of the lease and the
lessor’s cost or carrying amount (book value).
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…Accounting by Lessor
Normally, sales-type leases arise when manufacturers or
dealers use leasing as a means of marketing their products.
For example, a computer manufacturer will lease its computer
equipment (possibly through a captive) to businesses and
institutions.
Direct financing leases generally result from arrangements
with lessors that are primarily engaged in financing operations
(e.g., banks).
Lessors classify and account for all leases that do not qualify
as direct-financing or sales-type leases as operating leases.
The next slide shows the circumstances under which a lessor
classifies a lease as operating, direct-financing, or sales-type.

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…Accounting by Lessor

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Direct – Financing Method (Lessor)
Direct-financing leases are in substance the financing of an asset purchase
by the lessee.
In this type of lease, the lessor records a lease receivable instead of a leased
asset.
The lease receivable is the present value of the minimum lease payments
plus the present value of the unguaranteed residual value.
Remember that “minimum lease payments” include (1) rental payments
(excluding executory costs), (2) bargain-purchase option (if any), (3)
guaranteed residual value (if any), and (4) penalty for failure to renew (if
any).
Thus, the lessor records the residual value, whether guaranteed or not.
Also, recall that if the lessor pays any executory costs, then it should reduce
the rental payment by that amount in computing minimum lease payments.

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…Direct – Financing Method (Lessor)
The following presentation, using the data from the preceding
Caterpillar/Sterling example, illustrates the accounting treatment for a direct-
financing lease. Here the information relevant to Caterpillar in accounting for
this lease transaction is repeated.
1. The term of the lease is five years beginning January 1, 2012, non-cancelable,
and requires equal rental payments of $25,981.62 at the beginning of each year.
Payments include $2,000 of executory costs (property taxes).
2. The equipment (front-end loader) has a cost of $100,000 to Caterpillar, a fair
value at the inception of the lease of $100,000, an estimated economic life of
five years, and no residual value.
3. Caterpillar incurred no initial direct costs in negotiating and closing the lease
transaction.
4. The lease contains no renewal options. The equipment reverts to Caterpillar at
the termination of the lease.
5. Caterpillar sets the annual lease payments to ensure a rate of return of 10%
(implicit rate) on its investment as follows;

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…Direct – Financing Method (Lessor)
Fair value of leased equipment $100,000.00
Less: Present value of the residual value 0.00
Amount to be recovered by lessor through
lease payments $100,000.00
Five beginning-of-the-year lease payments
to yield a 10% return ($100,000 ÷ 4.16987 a)
$23,981.62
  a
PV of an annuity due of 1 for 5 years at 10%
 
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…Direct – Financing Method (Lessor)
As shown in the earlier analysis, the lease meets the criteria for
classification as a direct-financing lease for two reasons:
(1) the lease term equals the equipment’s estimated economic
life, and
(2) the present value of the minimum lease payments equals the
equipment's fair value.
It is not a sales-type lease because there is no difference
between the fair value ($100,000) of the loader and
Caterpillar’s cost ($100,000)
The lease receivable is the present value of the minimum lease
payments (excluding executory costs which are property taxes
of $2,000). Caterpillar computes it as follows.
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 …Direct – Financing Method (Lessor)
 Lease receivable = ($25,981.62 - $2,000) * Present value of an annuity due of 1 for 5 periods at 10%
= $23,981.62 * 4.16986
= $100,000
Caterpillar records the lease of the asset and the resulting
receivable on January 1, 2015 (the inception of the lease), as
follows.
Lease Receivable 100,000
Equipment 100,000
Companies often report the lease receivable in the statement of
financial position as “Net investment in finance leases.”
Caterpillar applies the effective-interest method and recognizes
interest revenue as a function of the lease receivable balance

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…Direct – Financing Method (Lessor)

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…Direct – Financing Method (Lessor)
 On January 1, 2015, Caterpillar records receipt of the first year’s lease
payment as follows.
Cash 25,981.62
Lease Receivable 23,981.62
Property Tax Expense/Property Taxes Payable 2,000.00
 On December 31, 2015, Caterpillar recognizes the interest revenue earned
during the first year through the following entry.
Interest Receivable 7,601.84
Interest Revenue 7,601.84
 At December 31, 2015, Caterpillar reports the lease receivable in its
statement of financial position among current assets or non-current assets,
or both.
 It classifies the portion due within one year or the operating cycle,
whichever is longer, as a current asset, and the rest with non-current assets.

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…Direct – Financing Method (Lessor)
 The following Illustration shows the assets section as it relates to lease
transactions at December 31, 2015
Non-current assets (investments)
Lease receivable ($76,018.38 - $16,379.78) $59,638.60
Current assets
Interest receivable $ 7,601.84
Lease receivable 16,379.78
 The following entries record receipt of the second year's lease payment and
recognition of the interest earned.
Jan 1, 2016 Cash 25,981.62
Lease Receivable 16,379.78
Interest Receivable 7,601.84
Property Tax Expense/Property Taxes Payable 2,000.00

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…Direct – Financing Method (Lessor)
Dec 31,2016 Interest Receivable 5,963.86
Interest Revenue 5,963.86
Journal entries through 2019 follow the same pattern except
that Caterpillar records no entry in 2019 (the last year) for
interest revenue.
Because the company fully collects the receivable by January
1, 2019, no balance (investment) is outstanding during 2019.
If Sterling buys the loader for $5,000 upon expiration of the
lease, Caterpillar recognizes disposition of the equipment as
follows.
Cash 5,000
Gain on Disposal of Equipment 5,000
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Operating Method (Lessor)
Under the operating method, the lessor records each rental receipt as
rental revenue.
It depreciates the leased asset in the normal manner, with the
depreciation expense of the period matched against the rental revenue.
The amount of revenue recognized in each accounting period is a level
amount (straight-line basis) regardless of the lease provisions, unless
another systematic and rational basis better represents the time pattern
in which the lessor derives benefit from the leased asset.
In addition to the depreciation charge, the lessor expenses maintenance
costs and the cost of any other services performed under the provisions
of the lease that pertain to the current accounting period.

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…Operating Method (Lessor)
The lessor amortizes over the life of the lease any costs paid to
independent third parties, such as appraisal fees, finder's fees, and
costs of credit checks, usually on a straight-line basis.
To illustrate the operating method, assume that the direct-financing
lease illustrated in the previous section does not qualify as a finance
lease.
Therefore, Caterpillar accounts for it as an operating lease. It records
the cash rental receipt as follows.
Cash 25,981.62
Rent Revenue 25,981.62
Caterpillar records depreciation as follows (assuming a straight-line
method, a cost basis of $100,000, and a five-year life).
Depreciation Expense 20,000
Accumulated Depreciation—Equipment 20,000
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Sales –Type Leases (Lessor)
 As already indicated, the primary difference between a direct-
financing lease and a sales-type lease is the manufacturer’s or
dealer’s gross profit (or loss).
 The following diagram presents the distinctions between direct-
financing and sales-type leases.

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…Sales –Type Leases (Lessor)
 In a sales-type lease, the lessor records the sales price of the asset, the
cost of goods sold and related inventory reduction, and the lease
receivable.
The information necessary to record the sales-type lease is as follows.
LEASE RECEIVABLE (also referred to as NET INVESTMENT). The
present value of the minimum lease payments plus the present value of
any unguaranteed residual value. The lease receivable therefore
includes the present value of the residual value, whether guaranteed or
not.
SALES PRICE OF THE ASSET. The present value of the minimum
lease payments.
COST OF GOODS SOLD. The cost of the asset to the lessor, less the
present value of any unguaranteed residual value
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…Sales –Type Leases (Lessor)
When recording sales revenue and cost of goods sold, there is a
difference in the accounting for guaranteed and unguaranteed
residual values.
The guaranteed residual value can be considered part of sales
revenue because the lessor knows that the entire asset has been sold.
But, there is less certainty that the unguaranteed residual portion of
the asset has been “sold” (i.e., will be realized).
 Therefore, the lessor recognizes sales and cost of goods sold only
for the portion of the asset for which realization is assured.
However, the gross profit amount on the sale of the asset is the
same whether a guaranteed or unguaranteed residual value is
involved.

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…Sales –Type Leases (Lessor)
To illustrate a sales-type lease with a guaranteed residual value
and with an unguaranteed residual value, assume the same
facts as in the preceding direct-financing lease situation.
The estimated residual value is $5,000 (the present value of
which is $3,104.60), and the leased equipment has an $85,000
cost to the dealer (Caterpillar).
Assume that the fair value of the residual value is $3,000 at the
end of the lease term.

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…Sales –Type Leases (Lessor)
COMPUTATION OF LEASE COLLECTION (10% ROI)
GUARANTEED OR UNGUARANTEED RESIDUAL VALUE
ANNUITY-DUE BASIS, INCLUDING RESIDUAL VALUE
Fair value of leased asset to lessor $100,000.00
Less: Present value of residual value
($5,000 * .62092,) 3,104.60
Amount to be recovered by lessor
through lease payments $ 96,895.40
Five periodic lease payments
($96,895.40 / 4.16986) $ 23,237.09

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…Sales –Type Leases (Lessor)

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…Sales –Type Leases (Lessor)
 Caterpillar makes the following entries

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Sales –Type Leases (Lessor)
Caterpillar makes the following entries

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…Sales –Type Leases (Lessor)

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End of Chapter Four

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