How do lessors account for direct-financing and sales-type leases?

The two major differences in the accounting treatment of a direct-financing lease and a sales-type lease are the gain or loss on the sale of the asset – there is no manufacturer’s or dealer’s gross profit or loss in a direct-financing lease – and initial direct costs at lease inception.  Accounting for finance leases subsequent to initial recognition is the same for direct-financing and sales-type leases – including journal entries for receipt of lease payments and recognition of earned interest income.

At lease inception, lessors recognize the value of both direct-finance and sales-type leases in their balance sheets as a lease receivable equal to the net investment in the lease.  The net investment is recorded in a contra account as unearned interest income to be recognized as revenue and amortized over the lease term using the EIR method.  However, the lessor in sales-type lease – the asset’s manufacturer or dealer – also records at lease inception sales revenue and the cost of goods sold. 

For direct-financing leases, initial direct costs are expensed by debiting unearned interest income, while for sales-type leases they are charged to operations in the year the sale is recorded.  In both direct-finance and sales-type leases, the lessee typically recognizes and pays executory costs.  Lease payments reduce the lease receivable while reducing the unearned income, which is recognized as the earning of the interest income.  If there is no reasonable certainty that the lessee will obtain ownership of the asset by the end of the lease term, the lessor depreciates the asset over the shorter of the lease term and its economic life.

In addition to the lease receivable, the lessor in a sales-type lease realizes a gross profit or loss on the sale of the asset at lease inception.  As with a normal sales transaction, the lessor’s gross profit or loss on the sale is the difference between its sales revenue (sales price) and cost of goods sold, with a debit to cost of goods sold and a credit to sales revenue.  The sales revenue equals the present value of the minimum lease payments discounted at the lease’s implicit interest rate, while cost of goods sold is usually recorded at the assigned inventory cost.

Whereas the present value of any guaranteed residual value is included in sales revenue, unguaranteed residual value reduces both sales revenue and COGS by its present value to recognize the fact that the lessor expects to receive the residual value at the end of the lease term.  Initial direct costs are either added to cost of goods sold or recognized as a selling expense of the period.