What Is a Sales Type Lease & How Is It Accounted For?

Leases are contractual agreements that grant one party, the lessee, the right to use an asset owned by another party, the lessor, for a specified period in exchange for payments. These arrangements are a common financing tool for businesses, allowing them to acquire access to necessary assets without the upfront cost of purchase. For accounting purposes, leases are classified differently, impacting how they appear on financial statements. The classification depends on the specific terms of the lease and dictates the accounting treatment for both the lessor and the lessee, providing transparency into financial obligations and asset utilization.

Characteristics of a Sales Type Lease

A sales-type lease represents a specific classification primarily from the lessor’s perspective. It signifies a transaction where the lessor is essentially selling the asset to the lessee, even though legal ownership may not immediately transfer. Under current accounting standards, specifically ASC 842, a lease qualifies as a sales-type lease for the lessor if it meets any one of five criteria.

One criterion is met if the lease agreement transfers ownership of the underlying asset to the lessee by the end of the lease term. This indicates that the lessee will ultimately gain control and title to the asset. Another criterion involves a purchase option that the lessee is reasonably certain to exercise. This option allows the lessee to buy the asset at a price significantly lower than its expected fair market value, making its exercise highly probable.

A lease can also be classified as sales-type if the lease term covers a major part of the remaining economic life of the underlying asset. While “major part” is not explicitly defined as a percentage in the standard, it generally implies a significant portion, such as 75% or more of the asset’s useful life. Furthermore, if the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset, it qualifies as a sales-type lease. “Substantially all” often refers to 90% or more of the asset’s fair value.

Lastly, if the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term, the lease is considered sales-type. This criterion applies when the asset is custom-made or modified specifically for the lessee’s use. Meeting any of these five criteria means the lessor accounts for the transaction as a sale of the asset.

Lessor Accounting Treatment

Once a lease is determined to be a sales-type lease, the lessor’s accounting reflects the transfer of the asset’s control to the lessee, akin to a sale. At the commencement of the lease, the lessor derecognizes the underlying asset from its balance sheet. This action removes the asset’s carrying value, signaling that the lessor no longer retains the primary risks and rewards of ownership.

Simultaneously, the lessor recognizes a “net investment in the lease” on its balance sheet. This net investment represents the present value of the future lease payments the lessor expects to receive, plus the present value of any residual value of the asset that is guaranteed by the lessee or a third party. The difference between this net investment in the lease (essentially the sales price) and the carrying amount of the derecognized asset is recognized as a selling profit or loss at lease commencement. This immediate recognition of profit or loss is a defining characteristic of sales-type leases for lessors.

Over the lease term, the lessor does not recognize rental revenue in the same way an operating lease would. Instead, the lessor earns and recognizes interest income on the net investment in the lease. This interest income reflects the financing component of the transaction, as the lessor has effectively converted the leased asset into a financial asset. The net investment in the lease is adjusted periodically, increasing for recognized interest income and decreasing as lease payments are collected from the lessee.

Lessee Accounting Treatment

For the lessee, accounting for leases under ASC 842 involves a dual classification model: finance leases and operating leases. A sales-type lease from the lessor’s perspective will typically be classified as a finance lease by the lessee. This occurs because the criteria that make a lease a sales-type lease for the lessor are generally the same criteria that classify it as a finance lease for the lessee.

At the commencement of a finance lease, the lessee recognizes a right-of-use (ROU) asset and a corresponding lease liability on its balance sheet. The ROU asset represents the lessee’s right to use the underlying asset for the lease term, while the lease liability is the present value of the future lease payments. The initial measurement of the ROU asset is generally equal to the lease liability, adjusted for any initial direct costs, prepaid lease payments, or lease incentives received.

Subsequently, over the lease term, the lessee accounts for the finance lease by recognizing both amortization expense on the ROU asset and interest expense on the lease liability. The ROU asset is typically amortized on a straight-line basis over the shorter of the lease term or the useful life of the underlying asset if ownership transfers. Interest expense is calculated on the outstanding balance of the lease liability, with the expense generally being higher in the earlier years of the lease term and declining over time as the liability is reduced.

Comparing Lease Classifications

Leases are categorized differently for lessors under ASC 842, including sales-type leases, direct financing leases, and operating leases. The primary distinction among these classifications, particularly between sales-type and direct financing leases, lies in the timing of profit recognition for the lessor. In a sales-type lease, the lessor recognizes a selling profit or loss at the commencement of the lease, treating the transaction as an immediate sale of the asset. This profit is calculated as the difference between the fair value of the asset and its cost or carrying amount to the lessor.

Conversely, in a direct financing lease, the lessor does not recognize an upfront selling profit. Instead, any profit is deferred and recognized over the lease term through interest income. This means a direct financing lease primarily reflects a financing arrangement where the lessor earns interest on the funds provided for the asset’s use. Both sales-type and direct financing leases involve the derecognition of the underlying asset and the recognition of a net investment in the lease by the lessor.

An operating lease, for the lessor, differs significantly as the lessor retains the underlying asset on its balance sheet and continues to depreciate it. No selling profit is recognized at lease commencement for an operating lease. Instead, the lessor recognizes lease revenue, often on a straight-line basis, over the lease term. For lessees, the classification is simpler, typically resulting in either a finance lease or an operating lease, both of which require recognition of a right-of-use asset and a lease liability on the balance sheet. The accounting for a lessee’s finance lease aligns with the economics of asset ownership, while an operating lease results in a single, straight-line lease expense on the income statement.