The Differences Between Sales Type Leases & Direct Financing Leases in Journal Entries

Leasing property, whether real property or equipment, often makes good business sense. One party may have a need but lack the means for a purchase. The other party, meanwhile, can have the asset but is willing to make it available as a way to generate income.

It would appear that leasing should be a pretty simple affair. Yet revenue from leases is represented differently in accounting ledgers depending on the nature of the rental agreement. Two similar kinds of leases, sales-type and direct financing, are nevertheless represented differently with regard to business income journals.

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A sales-type lease is a capital lease that allows the renter the interim use of an asset while the renter reports it as sold property for accounting purposes. It might contain an option to buy at the point of expiration. The sales-type lease is more identifiable by what it is not: an operating lease. Under an operating lease, full ownership is retained by the lessor with no prospect for ownership on the part of the lessee.

If, on the other hand, the lessor receives interest income and can demonstrate a profit or loss from the contract, this qualifies as a sales-type lease. If an HVAC systems manufacturer leases a system to a commercial real estate company, the maker will earn money over and above the costs of maintaining that system.

Like its sales-type counterpart, the direct financing lease is a capital lease. Payments, however, should reflect parity with the value of the asset as opposed to those based on a dollar figure higher than the asset's value. In other words, the total receivables should equal the book value of the asset.

Another difference is that manufacturers or dealers are forbidden from issuing a direct finance lease, which is more commonly given by a third-party institution. The biggest divergence between a sales-type vs. direct financing lease is the manner in which the lease is represented in the books.

Lease accounting serves to track the financial effect of a company's leasing enterprises. Three accounting statements perform this function.

The balance sheet, as an example, weighs assets against liabilities while representing shareholder equity. Cash flow statements, on the other hand, focus on a selected span of time, e.g. a month or fiscal quarter, and monitor the migration of money into and out of company accounts. Finally, income statements, or profit and loss (P&L) statements, follow revenue and expenses over a given stretch of time.

Pertaining to leases, the lease itself is reported by the lessor as an asset on the balance sheet. The individual payments the lessor receives will be entered as revenue on the cash flow and income statements.

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Income from a direct financing lease is documented as remittances roll in. The book value of the asset is deleted from the lessor's balance sheet and supplanted by the value of the payments. Any variation of received income against the book value of the asset is counted as implied interest.

Sales-type lease journal entries for the lessor show a portion of the total income earned from a lease at the commencement of the lease. The rest of the revenue is demonstrated over the ensuing months of the lease term. Since the sales-type lease provides for profit in excess of maintaining the property, that surfeit is recorded at the beginning. The remaining value of the lease is entered month by month, or in whatever time frame payments are made.