What are the differences between sales type leases and direct finance leases in journal entries?
In practice, the difference between a sale type lease and a direct finance lease is quite minimal. Both types are considered capital leases, which means that the lessor finances the leased asset but all ownership rights are transferred to the lessee. This is a common financial arrangement for equipment, real estate, and many other types of assets.
In the accounting sense, however, the difference between the type of sale and the type of direct financing is quite different.
Accounting for a finance lease
In a finance lease, the lessor recognizes the sale proceeds over time as the lease payments are made. When the asset is leased, the lessor removes the book value of the asset from its balance sheet and replaces it with a receivable equal to the book value. The internal rate of return on the asset – the difference in the cash flows of all monthly payments minus the carrying amount of the asset when it is sold – is used as the implicit interest rate for the lease.
This arrangement is analogous to how a bank would account for a loan. Each month the loan payment is paid and the bank records the interest part of the payment as income and the main part is used to reduce the loan balance.
As each payment is received under the finance lease, the lessor records income based on the portion of the implied interest based on the internal rate of return on the asset and the remainder would be deducted from the asset. claim on its balance sheet established for each direct finance lease. . The accounts are different, but the mechanism is very similar to the example of the bank.
Accounting for a sale-type lease
While direct finance accounting recognizes revenue over time as payments are made, the sale-type lease represents a portion of that income immediately at the start of the lease, with the remainder recognized over the term. of the rental contract.
The lessor must recognize the gross margin of the lease from the start of the lease. Gross margin is calculated as the present value of future cash flows from the lease less the carrying amount of the asset at the start of the lease, discounted at the implied internal rate of return. The residual value of the lease is then recognized as the type of direct financing as payments are received over time.
The sale-type lease therefore allows the lessor to recognize more income at the start of the lease, while the direct finance arrangement does not recognize any income up front but then catches up with the delay as the lease begins. the rental contract is progressing.
In both cases, the lessee must enter the asset on his balance sheet as a fixed asset. The lessor no longer displays the asset on its balance sheet but instead displays the value of the finance contract as a receivable.
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