Under U.S. GAAP there are two alternative types of capital leases when dealing with lessors: a sales-type lease and a direct financing lease. IFRS does not distinguish between them. The accounting is the same for IFRS and U.S. GAAP.

Sales-Type Lease

Sale-leaseback (S-L) transactions are sales of property by the owner, who then leases the property back from the buyer-lessee. The seller (lessor) leases its own property, rather than selling it outright. Such leases involve two transactions:

• Selling the property at the time the lease is initiated.
• Providing financing to the lessee.

At the inception of the lease, a manufacturer treats the transaction as if it sold the asset in exchange for an investment in a capital lease. It recognizes a gross profit from the sale of the asset.

• Sales = the lower of the present value of minimum lease payments or the fair value of the asset. The total lease payments (un-discounted) are known as the lessor's Gross Investment in Lease.
• Cost of goods sold = cost of leased asset - present value of residual value
• Gross profit (manufacturer's profit) = sales - cost of goods sold.
• The balance sheet also records an asset: net investment in lease = present value of lease payment + present value of residual value. The difference between gross investment in a lease and net investment in a lease is the unearned interest income, which is the financing income component of the manufacturer's total profit.

Periodic Transactions

• Each year over the life of the lease, interest income is recognized using the following formula: interest income = the year's beginning value of net investment in lease x implicit interest rate of the lease. It is a cash flow from operations under U.S. GAAP and either an operating or investing cash flow under IFRS.
• The difference between lease payment and interest income represents the portion of Net Investment in Lease recovered during the year. Recovery in Net Investment in Lease is an investment cash flow.
• The Net Investment in Lease at the end of the year is: the year's beginning value of Net Investment in Lease - Net Investment Recovery.

Direct Financing Lease

In a direct financing lease, a leasing company purchases a property from a manufacturer and then leases the equipment to the lessee. The distinction between a sales-type lease and a direct financing lease is the presence/absence of a manufacturer's or dealer's profit. In a direct financing lease, the cost of the leased asset equals its market value, so only financing income is involved. In a sales-type lease, the cost of the leased asset is less than its market value (the present market value of lease payments), creating a manufacturer's or dealer's profit in addition to financing income.

As in a direct financing lease, the lessor's original cost or the carrying value (prior to the lease) of the asset approximates the market value of the leased asset (the present value of the MLPs); such leases are pure financing transactions and financial reporting for direct financing leases reflects this fact. No sale is recognized at the inception of the lease and there is no manufacturing or dealer profit. Only financing income is reported.

Effects of Operating and Capital (Finance) Leases on a Lessor's Financial Statements

Balance Sheet:

• Operating Lease: The book value of the asset is reported on the balance sheet as a long-term asset, net of accumulated depreciation.
• Capital Lease: Lease receivable, instead of the asset, is reported on the balance sheet, and is amortized over the life of the lease.
• For a sales-type lease, the gain from the sale of the asset recognized at the inception of the lease increases shareholders' equity. Therefore, a sales-type lease results in higher total assets and higher shareholders' equity.

Income Statement:

• Operating Lease: At the inception of the lease, no income is recognized. Over the life of the lease, income tends to be constant if straight-line depreciation is used.
• Capital Lease: Over the life of the lease, interest income tends to decline over time.
• At the inception of the lease, the gain from the sale of the lease asset is recognized for a sales-type lease. The sales-type lease reports substantially higher income at the inception of the lease, thus recognizing income earlier than an operating lease. However, total income over the life of the lease is the same for both. Although IFRS does not have a provision for sales-type leases, the accounting treatment is the same if there's a profit at the inception of the lease.

Cash Flow Statement:

• Operating Lease: At the inception of the lease, no cash flow occurs. Over the term of the lease, the entire lease payment is reported as an operating cash inflow.
• Capital Lease: Over the term of the lease, the lease payment from the lessee is allocated to interest income (an operating cash inflow under U.S. GAAP, and either an operating or an investing cash flow under IFRS) and net investment recovery (investing inflow).
• Sales-type leases report higher operating cash flow at the inception of the lease, but lower operating cash flow over the lease term.

Example

The lessor has an asset on the books with a cost of $1,000. The lessor leases the asset out as a sales-type lease with the present value of the minimum lease payments equal to $1,300. The total minimum lease payments are $2,000 over the lease term.

The lessor recognizes a sale of $1,300 and cost of sales of $1,000, which results in a gross profit of $300 ($1,300 - $1,000).

The corresponding entry is the recognition of a net investment in leases of $1300. The net investment in leases is made up of a gross investment - unearned finance income. Gross investment is equal to the remaining minimum lease payments (not discounted) and the unearned finance income is the interest income that will be earned over the remainder of the lease. In this instance these are as follows:

Gross investment in lease: $2,000
Unearned finance income: ($700)
Net investment: $1,300

As you can see, the unearned finance income is the difference between the minimum lease payments and the present value of the minimum lease payments. This amount amortizes on the income statement as interest income as the lease is repaid.