Sales Type Lease
A Sales Type Lease refers to a specific type of leasing arrangement primarily used in accounting for the lessor (the entity that owns the asset and leases it to another party). In a Sales Type Lease, the lessor recognizes both the profit (or loss) from the sale of the leased asset and the interest income over the lease term. This type of lease essentially means that the lessor is both selling the asset (recognizing profit or loss on the sale) and financing the sale (earning interest revenue over time).
Characteristics and Criteria for a Sales Type Lease (from the perspective of the lessor):
- Transfer of Ownership: By the end of the lease term, the ownership of the asset transfers to the lessee.
- Purchase Option: The lease might contain a bargain purchase option, allowing the lessee to purchase the asset at a price significantly lower than its expected fair market value.
- Lease Term: The lease term is for the major part of the remaining economic life of the asset.
- Present Value: The present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.
- Collectibility: The collectibility of the lease payments is reasonably predictable.
- No Additional Costs: There are no material uncertainties surrounding the amount of unreimbursable costs to be incurred by the lessor.
When a lease meets any of the above criteria (as per U.S. GAAP), the lessor will account for the lease as a Sales Type Lease. This means the lessor will recognize the selling profit (or loss) upfront at the inception of the lease, in addition to recognizing interest income over the lease term.
Example of Sales Type Lease
Let’s illustrate the concept of a Sales Type Lease with a detailed example:
Lessee: BuildIt Inc.
- Asset Details: MachineryCorp has a machine that has a fair value of $500,000 and a carrying amount (cost to MachineryCorp) of $400,000.
- Lease Term: BuildIt Inc. agrees to lease this machine from MachineryCorp for a period of 4 years.
- Lease Payments: Annual payments of $145,000 at the beginning of each year.
- Interest Rate: Both parties agree on an implicit interest rate of 8%.
- Residual Value: At the end of the lease term, it’s expected that the machine will have no residual value.
Determine the Lease Type:
Given the parameters, it’s determined that this lease agreement meets the criteria of a sales type lease. For instance, the present value of the lease payments ($145,000 x 3.3122) is equal to the fair value of the machine ($500,000).
Accounting for MachineryCorp (Lessor):
- Initial Recognition:
- Gross Investment in the lease: $145,000 x 4 = $580,000
- Cost of the machine (carrying amount) = $400,000
- Profit on the “sale” = Fair value – Carrying amount = $500,000 – $400,000 = $100,000
- Year 1:
- Cash received: $145,000
- Interest Revenue (8% of $580,000): $46,400
- Principal (Cash received – Interest revenue): $145,000 – $46,400 = $98,600
- Outstanding lease receivable decreases by the principal amount: $580,000 – $98,600 = $481,400 (this will be the basis for interest computation for year 2)
In the subsequent years, the same process will follow. The interest revenue will be calculated as 8% of the outstanding lease receivable, and the difference between cash received and interest revenue will be the principal reduction.
By the end of the lease term, MachineryCorp would have recognized the initial profit from the “sale” of the machine, as well as interest revenue from the financing aspect over the 4 years. BuildIt Inc., on the other hand, would account for the machine as a capitalized asset on its balance sheet, recognizing depreciation over the lease term or useful life of the asset.