In this article, we’ll explore the journal entries for a sales-type lease under ASC 842 from the lessor’s perspective. A detailed example is provided in a step-by-step manner to enhance the understanding of this topic.
Related reading:
ASC 842 Journal Entries – Direct Financing Lease (Lessor)
ASC 842 Journal Entries – Operating Lease (Lessee and Lessor)
ASC 842 Journal Entries – Finance Lease (Lessee)
Month-To-Month Lease Under ASC 842
Basics of Sales-type Lease
- Definition: A sales-type lease is one where the lessor (the entity leasing the asset to the lessee) recognizes both the selling profit (or loss) and interest income on the lease. (Think of it like this: if it’s a “sales,” then there is a profit recognition.)
- Criteria for Classification (satisfies any of the following):
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the asset, which the lessee is reasonably certain to exercise.
- The lease term is for a major part of the remaining economic life of the underlying asset. (The “75%” Rule – the lease term is at least 75% of the economic life of the asset.)
- 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. (The “90%” rule – the PV of the lease payment and guaranteed residual value is at least 90% of the fair value of the asset.)
- 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.
Hint: The criteria for a sales-type lease are the same as those that qualify a lease as a “finance lease” from the lessee’s perspective.
- Financial Statement Impact: When a sales-type lease is recognized:
- The lessor derecognizes or removes the underlying asset from its balance sheet.
- The lessor recognizes a Net Investment in the Lease, which is an asset (think of it as “lease receivable”). It represents the present value of future lease payments and residual value (both guaranteed or unguaranteed by the lessee).
- Any difference between the Net Investment in the Lease and the carrying amount of the derecognized asset is recognized as selling profit or loss.
- Over the lease term, the lessor recognizes interest income on its Net Investment in the Lease.
We will illustrate the financial impact using journal entry examples below.
- Difference between a Sales-type lease and a Direct financing lease: The primary difference revolves around the recognition of selling profit or loss at the inception of the lease. A sales-type lease recognizes a selling profit or loss at the commencement date. A direct financing lease does not record that.
Related reading:
What Is a Lease Accountant and What Do They Do?
Journal Entries Example – Sales-type lease
For clarity, we’ll present two distinct scenarios:
- Scenario one: Sales-type lease with zero residual value, and no return from the lessee.
- Scenario two: Sales-type lease with a residual value, and the lessee will return the asset.
Scenario One
“No residual value, no return.”
- The Oven Lease Company leased oven equipment to the Pho My Life Noodle Shop.
- Term: 3 years
- Payment: $3,672 a year
- Interest rate: 5%
- Cost of the equipment: $8,000
First, we will need to calculate the present value of the lease payment. Using a calculator, the PV comes out to be $10,000.
Initial recognition:
Net Investment in the Lease = PV of lease receivable ($10,000) + Residual Value ($0) = $10,000
Selling profit = Net Investment in the Lease ($10,000) – Cost of the Equipment ($8,000) = $2,000
The Oven Lease Company (Lessor) will debit or recognize a $10,000 asset called Net investment in the Lease based on the calculation above, remove or credit the equipment from the book ($8,000) while recognizing a selling profit ($2,000)
Year 1:
Interest Income: Outstanding Net Investment $10,000 * interest rate 5% = $500
Principal Reduction: Payment $3,672 – Interest $500 = $3,172
Ending Net Investment Balance: $10,000 – $3,172 = $6,828
The Oven Lease Company (Lessor) will debit cash for $3,672 for the lease payment, and credit Interest Income for $500. The difference, or the principal reduction of $3,172, is a credit to the Net Investment in the Lease.
Year 2:
Interest Income: Outstanding Net Investment $6,828 * interest rate 5% = $341
Principal Reduction: Payment $3,672 – Interest $341 = $3,331
Ending Net Investment Balance: $6,828 – $3,331 = $3,497
Similar to year 1, the lessor debits cash for $3,672 for the lease payment, and credits Interest Income for $341. The difference of $3,331 is a credit to the Net Investment in the Lease.
Year 3:
Interest Income: Outstanding Net Investment $3,497 * interest rate 5% = $175
Principal Reduction: Payment $3,672 – Interest $175 = $3,497
Ending Net Investment Balance: $3,497 – $3,497 = $0
Similar to year 1, the lessor debits cash for $3,672 for the lease payment, and credits Interest Income for $175. The difference of $3,497 is a credit to the Net Investment in the Lease, which will completely zero out the asset balance.
To conclude, at the end of the lease term, the lessor will have recognized the selling profit of $2,000 at the commencement date and interest income of $1,016 from the lease term. ($500 from year 1, $341 from year 2, and $175 from year 3). The Net investment in the Lease account is completely zeroed out at the end as well.
Here is the amortization of the Net Investment in the Lease account.
Scenario Two
“With residual value, and lessee will return the asset.”
- The Oven Lease Company leased oven equipment to the Pho My Life Noodle Shop.
- Term: 3 years
- Payment: $2,847 a year
- Interest rate: 5%
- Residual value: $2,000
- Cost of the equipment: $8,000
First, let’s calculate the present value of the lease payment. Using a calculator, the PV comes out to be $7,753.
Second, let’s calculate the present value of the equipment’s residual value, given the lessor will receive it after 3 years. Using a calculator, the PV comes out to be $1,728.
Initial recognition:
Net Investment in the Lease = PV of lease receivable ($7,753) + PV of Residual Value ($1,728) = $9,481
Selling Profit = Net Investment in the Lease ($9,481) – Cost of the Equipment ($8,000) = $1,481
The Oven Lease Company (Lessor) will debit or recognize a $9,481 asset – Net investment in the Lease based on the calculation above, remove or credit the equipment from the book ($8,000), and record a selling profit ($1,481)
Year 1:
Interest Income: Outstanding Net Investment $9,481 * interest rate 5% = $474
Principal Reduction: Payment $2,847 – Interest $474 = $2,373
Ending Net Investment Balance: $9,481 – $2,373 = $7,108
The Oven Lease Company (Lessor) will debit cash for $2,847 for the lease payment, and credit Interest Income for $474. The difference, or the principal reduction of $2,373, is a credit to the Net Investment in the Lease.
Year 2:
Interest Income: Outstanding Net Investment $7,108 * interest rate 5% = $355
Principal Reduction: Payment $2,847 – Interest $355 = $2,492
Ending Net Investment Balance: $7,108 – $2,492 = $4,616
Similar to year 1, the lessor debits cash for $2,847 for the lease payment, and credits Interest Income for $355. The difference of $2,492 is a credit to the Net Investment in the Lease.
Year 3:
Interest Income: Outstanding Net Investment $4,616 * interest rate 5% = $231
Principal Reduction: Payment $2,847 – Interest $231 = $2,616
Ending Net Investment Balance: $4,616 – $2,616 = $2,000
Similar to year 1 and 2, the lessor debits cash for $2,847 for the lease payment, and credits Interest Income for $231. The difference of $2,616 is a credit to the Net Investment in the Lease, leaving the $2,000 residual value in the account balance.
Asset Return
When the Pho My Life Noodle Shop (Lessee) returns the oven equipment to The Oven Lease Company (Lessor), the following journal entry is recorded.
Essentially, the equipment is returned to the lessor’s book (by debiting Equipment for $2,000), and the remaining balance in Net Investment in the Lease is zeroed out as well (through a credit of $2,000).
To conclude, at the end of the lease term, the lessor will have recognized the selling profit of $1,481 at the commencement date and interest income of $1,060 from the lease term. ($474 from year 1, $355 from year 2, and $231 from year 3). The equipment with a residual value of $2,000 is returned to the lessor’s book, and the Net investment in the Lease account is completely zeroed out at the end.
Here is the amortization of the Net Investment in the Lease account.
Please note that the two scenarios presented above are simplified examples illustrating the basic journal entries for Sales-type leases from the lessor’s perspective. In the real world, situations are more nuanced, such as considering whether the residual value is guaranteed vs unguaranteed and whether the return is probable.
Key Takeaways
- A sales-type lease allows the lessor to recognize both selling profit and interest income. The classification criteria are identical to the finance lease on the lessee side.
- At the commencement date, a Net Investment in the Lease account (asset account) is recognized, which combines the present value of lease payment receivable and the residual value of the asset if it will be returned at the end of the lease.
- Similarly to other amortizations, the Net Investment in the Lease account is amortized by the lease payment minus the interest income. The return of the asset from the lessee will also reverse the balance. As a result, by the end of the lease term, the Net Investment in the Lease account will be zeroed out.
