Sales Type Lease- LESSOR

Objectives:
- To understand a sales type lease on the part of lessor.
- To define gross investment and net investment in a sales type lease.
- To recognize gross income on sale and interest income in a sales type lease.

Introduction
- The lessor in a sales type lease is actually a manufacturer or dealer that uses the lease as a means
of facilitating the sale of product.
- The accounting for a sales type lease exhibits many similarities to that for a direct financing lease.
- However, a sales type lease involves the recognition of a manufacturer or dealer profit on the
transfer of the asset to the lessee in addition to the recognition of interest income.

Sales Type Lease

1. Gross investment in the lease is equal to the gross rentals for the entire lease term plus the
absolute amount of the residual value, whether guaranteed or unguaranteed. (This is the same
gross investment in a direct financing lease.)

2. Net investment in the lease is equal to the present value of the gross rentals plus the present
value of the residual value, whether guaranteed or unguaranteed.

3. Unearned interest income is the difference between the gross investment and net investment in
the lease.

4. Sales revenue in equal to the net investment in the lease (present value of lease payments) or fair
value of the asset, whichever is lower.

5. Cost of goods sold is equal to the cost of the asset sold minus the present value of unguaranteed
residual value plus the initial direct cost paid by the lessor.

6. Gross income is the usual formula of sales revenue minus cost of goods sold.

7. Initial direct cost is experienced immediately in a sales type lease as component of cost of goods
sold.

Intermediate Accounting | Acc003 Cash and Cash Equivalent

Journal entries-Books of Lessor Company

1. To record the sale:

Lease receivable 2,000,000
Sales 1,440,000
Unearned interest income 560,000
The gross income of P440, 000 is not separately recorded because it is included already in the sales
revenue.

2. To record the cost of goods sold, assuming the perpetual system is used:
Cost of goods sold 1,000,000
Inventory 1,000,000

3. To record the collection of the annual rental:

Cash 400,000
Lease receivable 400,000

4. To record the interest income for 2021:

Unearned interest income 172,800
Interest income (12% x 1,440,000) 172,800

Sales type lease with residual value

Lessor Company is a dealer in machinery.

On January 1, 2021, a machinery, is leased to another entity with the following provisions:

Annual rental payable at the end of each year 800,000

Lease term 5 years
Useful life of machinery 5 years
Cost of machinery 2,000,000
Residual value 200,000
Initial direct cost paid by lessor 100,000
Implicit interest rate 10%
Present value of an ordinary annuity of 1 for 5 periods at 10% 3.7908
Present value of 1 for 5 periods at 10% 0.6209

At the end of the lease term on December 31, 2025, the machinery shall revert to Lessor Company.

The perpetual inventory system is used.

Note that the residual value may be guaranteed or unguaranteed.

Intermediate Accounting | Acc003 Cash and Cash Equivalent

Journal entries on January 1, 2021

Lease receivable 4,200,000

Cost of goods sold 2,000,000
Sales 3,156,820
Unearned interest income 1,043,180
Inventory 2,000,000

Cost of goods sold 100,000

Cash 100,000

The initial direct cost is charged directly to cost of goods sold.

Sales 3,156,820
Cost of goods sold 2,100,000

Gross income 1,056,820

Cost of machinery sold 2,000,000

Initial direct cost 100,000

Cost of goods sold 2,100,000

Intermediate Accounting | Acc003 Cash and Cash Equivalent

Observe that the lease receivable and unearned interest income are the same whether the scenario is
guaranteed or unguaranteed residual value.

However, there is a difference in the computation of the sales and the cost of goods sold.

Under the residual value guarantee scenario, the present value of the residual value is included in the
sales revenue because the lessor knows that the entire asset has been sold.

However, under the unguaranteed residual value scenario, the present value of the unguaranteed residual
value is not included in the sales revenue.

Accordingly, the present value of the unguaranteed residual value is deducted from the cost of
unguaranteed residual value is deducted from the cost of the underlying asset in computing cost of goods
sold.

The reason is that this portion of the leased asset is in effect “not sold” in the sense that the lessor will be
receiving back at the end of the lease term the underlying asset with unguaranteed residual value of
P200,000 and present value of P124,180.

Moreover, the unguaranteed residual value is not considered lease payment as far as the lessee is
concerned.

Intermediate Accounting | Acc003 Cash and Cash Equivalent

Journal entries

To record the sale and the initial direct cost on January 1, 2021 under the concept of unguaranteed
residual value:

Lease receivable 4,200,000

Cost of goods sold 1,875,820
Sales 3,032,640
Unearned interest income 1,043,180
Inventory 2,000,000

Cost of goods sold 100,000

Cash 100,000

Journal entries-December 31, 2021

1. Cash 800,000
Lease receivable 800,000

2. Unearned interest income 315,682

Interest income 315,685

Journal entries-December 31, 2022

1. Cash 800,000
Lease receivable 800,000

2. Unearned interest income 267,250

Interest income 267,250

Intermediate Accounting | Acc003 Cash and Cash Equivalent

Return of asset to lessor

It is to be pointed out that in the illustration the sales type lease provides that the underlying asset shall
revert to the lessor upon termination of the contract.

However, if the underlying asset shall not revert to the lessor, the residual value is completely ignored by
the lessor in the computation of unearned interest income and gross income on the sale.

The underlying asset shall remain with the lessee if the lease provides for either a purchase option that is
reasonably certain to be exercised or transfer of title to the lessee upon the lease expiration.

Sales type lease with purchase option

An entity is a dealer in equipment. On January 1, 2021, an equipment is leased to another entity with the
following provisions:

Annual rental payable at the end of the year 500,000

Lease term 4 years
Useful life of equipment 5 years
Cost of equipment 1,500,000
Initial direct cost paid by lessor 100,000
Purchase option 200,000
Implicit interest rate 8%
PV of an ordinary annuity of 1 at 8% for 4 periods 3.312
PV of 1 at 8% for 4 periods 0.735

It is reasonably certain that the lease shall exercise the purchase option on December 31, 2024.

Intermediate Accounting | Acc003 Cash and Cash Equivalent

Journal entry- January 1, 2021

If the perpetual system is used, the journal entry to record the sale is:

Lease receivable 2,200,000

Cost of goods sold 1,100,000
Sales 1,803,000
Unearned interest income 397,000
Inventory 1, 000,000
Cash 100,000

Table of amortization

Table of amortization of the net lease receivable and interest income:

Payment represents the annual rental.

Interest is equal to the preceding present value times the interest rate.

Thus, for 2021, P1, 803,000 times 8% equals P144, 240, and so on.

Principal is the portion of the annual rental payment after deducting interest.

Intermediate Accounting | Acc003 Cash and Cash Equivalent

Thus, for 2021, P500, 000 minus P144, 240 equals P355, 760 and so on.

Present value is the balance of the present value after deducting the principal payment.

Thus, on December 31, 2021, P1, 803,000 minus P355, 760 equals P1, 447,240 and so on.

Journal entries

Exercise of purchase option

On December 31, 2024, if the entries are properly posted, the lease receivable had a balance of P200, 000
equal to the purchase option and the unearned interest income had a zero balance.

The purchase option is exercised by the lessee on December 31, 2024.

Cash 200,000
Lease receivable 200,000

Nonexercise of purchase option

The purchase option is not exercised by the lessee and the fair value of the underlying asset is P100, 000
only.

Inventory 100,000
Loss on finance lease 100,000
Lease receivable 200,000

Actual sale of underlying asset

When a lessor actually sells an asset that it has been leasing under a finance lease, the difference between
the sale price and the carrying amount of the lease receivable is recognized in profit or loss.

Intermediate Accounting | Acc003 Cash and Cash Equivalent

The carrying amount of the lease receivable is equal to the balance of the lease receivable minus the
unearned interest income.

Illustration

Disclosures-Lessor

A lessor shall disclose the following amounts for the reporting period:

1.For finance lease:

a. Selling profit or loss

b. Finance income on the net investment in the lease

c. Income relating to variable lease payments not included in the measurement of net investment in
the lease.

2. For operating lease, lease income, separately disclosing income relating to variable lease payments that
do not depend on an index or rate.

Additional disclosures

A lessor shall disclose additional qualitative and quantitative information about leasing activities
necessary to assess the
effect of leases on financial position, financial performance and cash flows.

Intermediate Accounting | Acc003 Cash and Cash Equivalent

This additional information includes, but is not limited to, information that helps users of financial
statements to assess:

1. The nature of the lessor’s leasing activities

2. How the lessor manages the risks associated with any rights it retains in the underlying asset.

In particular, a lessor shall disclose its risk management strategy for the rights it retains in
underlying asset, including any means by which the lessor reduces that risk.

Intermediate Accounting | Acc003 Cash and Cash Equivalent