In practice, the difference between a sales type lease and a direct financing lease is pretty minimal. Both types are considered capital leases, meaning the lessor finances the leased asset but all the rights to ownership transfer to the lessee. This is a common financial arrangement for equipment, real estate, and many other asset types.
In the accounting sense, however, the difference between the sales type and the direct financing type are quite different.
Accounting for a direct financing lease
In a direct financing lease, the lessor accounts for the income from the sale over time as the lease payments are made. When the asset is leased, the lessor removes the asset's book value 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 cash flows from all the monthly payments less the book value of the asset when it was sold -- is used as the implied 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 recognizes the interest portion of the payment as income and the principal portion goes to reduce the loan's balance.
As each payment is received in the direct financing lease arrangement, the lessor records income based on the implied interest portion based on the asset's internal rate of return and the remainder would be netted from the receivable on its balance sheet set up for each direct financed lease. The accounts are different, but the mechanism is very similar to the bank example.
Accounting for a sales type lease
While the direct financing accounting recognizes income over time as payments come in, the sales type lease accounts for a portion of that income immediately upon the inception of the lease, with the remainder accounted for over the term of the lease.
The lessor should recognize the gross profit from the lease immediately upon the start of the lease. The gross profit is calculated as the present value of the future cash flow from the lease less the book value of the asset at the start of the lease, discounted at the implied internal rate of return. The remaining value of the lease is then accounted for like the direct financing type as payments are received over time.
The sales type lease, therefore, allows the lessor to recognize more revenue at lease inception, while the direct financing arrangement recognizes no revenue up front but then catches up as the lease progresses.
In both cases, the lessee should carry the asset on its balance sheet as a fixed asset. The lessor no longer shows the asset on its balance sheet but instead will show the value of the financing agreement as a receivable.
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