Sales-Type Leases Accounting Explained (With Example) - ASC 842

Introduction

Sales-type leases are a common arrangement for manufacturers or dealers who lease assets to customers. Under ASC 842 Leases, these leases allow lessors to recognise revenue, selling profit, and interest income while accounting for the net investment in the lease. The accounting treatment closely mirrors that of a finance lease under IFRS 16 for manufacturer or dealer lessors, with key US GAAP-specific guidance on recognition, measurement, and derecognition.

Quick Explanation of Sales-Type Leases

A sales-type lease is a lease in which the lessor recognises profit or loss at commencement because the lease effectively represents a sale of the underlying asset. The accounting includes:

• Recognition of a net investment in the lease (lease receivable plus unguaranteed residual asset);
• Recognition of selling profit or loss upfront;
• Recognition of interest income over the lease term.

The main distinction from a direct financing lease is that the net investment in the lease reflects the asset's fair value (cost plus profit), whereas direct financing leases deduct selling profit from the net investment.

Requirements to Be a Sales-Type Lease

A lease qualifies as a sales-type lease if it meets any of the following criteria:

1. Transfer of ownership to the lessee by the end of the lease term.
2. Purchase option reasonably certain to be exercised by the lessee.
3. Lease term covers the major part of the remaining economic life of the asset.
   Note: This does not apply if the lease starts near the end of the asset’s economic life.
4. Present value of lease payments plus residual value guaranteed by the lessee equals or exceeds substantially all of the asset’s fair value.
5. Specialised asset that will have no alternative use to the lessor at the end of the lease term.

Recognition of Sales-Type Leases

At the commencement date, the lessor shall:

• Recognise the net investment in the lease in accordance with 842-30-30-1.
• Recognise selling profit or loss (fair value minus carrying amount).
• Account for initial direct costs:
  • If fair value ≠ carrying amount → expense immediately
  • If fair value = carrying amount → defer costs and include in net investment

After commencement, the lessor recognises:

• Interest income on the net investment using the implicit rate.
• Variable lease payments not included in the net investment as income when they occur.
• Impairment of the net investment in accordance with ASC 310.

Measurement of Sales-Type Leases

Initial Measurement of Sales-Type Leases

Net investment in the lease includes:

1. Lease receivable: Present value of lease payments not yet received plus any guaranteed residual asset.
2. Unguaranted residual asset: Present value of residual value not guaranteed by the lessee or any third party.

Subsequent Measurement of Sales-Type Leases

• Interest income: increases the carrying amount over time.
• Lease payments: reduce the carrying amount.
• The lease is not remeasured unless modified.
• Variable lease payments are recognised in profit or loss in the period they occur.
• Impairment must be assessed and recorded when necessary.

Impairment of the net investment must also be considered.

Derecognition

If a sales-type lease is terminated early:

1. First, test the net investment for impairment under ASC 310.
2. Reclassify the net investment to the appropriate asset category.
3. Account for the underlying asset according to relevant ASC guidance.

Practical Example

Scenario:

• Lease commencement: 1 Jan 2026
• Ownership transfers to the lessee at the end of the lease term
• Term: 4 years (ends 31 Dec 2029)
• Monthly payments: 2,000 (in arrears)
• Fair value: 80,000
• Carrying value: 75,000

Calculation:

• PV of payments: 80,000
• Implicit rate: 9.66%
• Net investment in lease: 80,000

Initial Measurement Journal Entries:

Dr Net Investment in Lease   80,000
Cr PPE                             75,000
Dr Cost of Sales             75,000
Cr Revenue                         80,000

Selling profit of 5,000 is therefore recognised upfront.

Subsequent Measurement Journal Entries:

• Net investment increases with interest each month, calculated by multiplying the net investment in the lease with the rate implicit in the lease.
• Lease payments are credited from the net investment in the lease balance.

Conclusion

Sales-type leases under ASC 842 allow lessors to recognise revenue, selling profit, and interest income efficiently. The accounting treatment is similar to IFRS 16 manufacturer or dealer leases, with key distinctions in net investment measurement and derecognition guidance. Careful application of recognition, subsequent measurement, and impairment rules ensures compliance with US GAAP.

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