ASC 842 Lessor Accounting Sales-Type Lease Example

Copier lease example

8 years

Lease term at a
price of $1000/
month

12 years

Estimated
remaining economic
life

$54,000

Carrying amount

$62,000

Fair value at the commencement date

$12,000

Expected residual
value of asset at the end
of term

15.219%

rate

You enter into an eight-year lease of a copier with a lessee, receiving monthly lease payments of $1,000, payable at the beginning of each month. The copier has a 12-year estimated remaining economic life, a carrying amount of $54,000, and a fair value of $62,000 at the commencement date. You are expecting the residual value of the asset to be $20,000 at the end of the lease term, none of which is guaranteed. The lease does not transfer ownership of the underlying asset to the lessee or contain an option for the lessee to purchase the underlying asset. You are incurring $2,000 in initial direct costs in connection with obtaining the lease.

The rate implicit in the lease is 15.219%, the rate at which the PV of lease payments including any residual value, is equal to the fair value of the underlying asset. This rate is automatically calculated by EZLease when entering the lease terms.

Lease classification

As there are no variable payments, we will proceed with performing the five finance vs. operating tests.

There is no automatic transfer as part of the lease agreement, so criterion #1 is not met.

The lease does not contain a purchase option, so criterion #2 is not met.

The lease term of eight years is less than the majority of the economic life of 12 years (using 75% as benchmark), so criterion #3 is not met.

To perform the PV test, we’ll have to calculate the PV of monthly lease payments of $1,000 for eight years, and the discount rate to be used for PV calculation (i.e., 15.219%). The PV of the lease payments comes out to $56,035.17, which substantially represents the fair value of the underlying asset of $62,000 (using 90% as benchmark). So, criterion #4 is met and we’ll classify this lease as a sales-type lease.

PV test

$1,000

For 8 years

15.219%

Discount rate

$56,035.17

PV of lease payments

$62,000

Fair value of asset

Criterion #4 is met and we’ll classify this lease as a sales-type lease.

At the commencement date, you will recognize the net investment (lease receivable, the PV of the payments plus unguaranteed residual asset, and the PV of the unguaranteed residual) in the lease, along with selling profit or loss, and derecognize the underlying asset at carrying value. Subsequently, monthly, you will increase the value of net investment by the interest income and reduce it to reflect the lease payments received.

Lease classification criteria

Under lessor accounting, leases are classified as sales-type, direct financing, and operating leases.
To determine the type of lease you have, use the following rules.

First, if any of the following five criteria is met, the lease would be classified as sales-type for lessor and finance for lessee.

Automatic transfer of ownership at the end of the lease
Purchase option that is reasonably certain to be exercised.
The lease term is for the major part (75% or above) of the remaining economic life of the underlying asset.
Present value (PV) of the lease payments (including any residual value guaranteed by the lessee) represents substantially all (90% or above) of the fair value of the underlying asset.
The asset is of a specialized nature.

If none of the above are met, the lease would be classified as either a direct financing lease or an operating lease.

Then, to determine if the lease is a direct financing lease or an operating lease, follow these steps. If both of the following criteria are met, a lessor shall classify the lease as a direct financing lease:

The present value (PV) of the lease payments (including any residual value guaranteed by the lessee or a third party) represents substantially all (90% or above) of the fair value of the underlying asset.
It is probable that the lessor will collect lease payments plus any amount necessary to satisfy a residual value guarantee.

If the lease meets neither the above criteria for a sales-type nor for a direct financing lease, then it should be classified as an operating lease.

Lessors need to perform an additional classification test, in accordance with the Accounting Standards Update (ASU) 2021-05:

Even if one of the above criteria is met, a lessor is required to classify a lease as operating if:

The payments for the lease are partially or entirely variable; and
Classifying it as sales-type or direct financing classification would result in a selling loss.

Easy testing.

Load this example into EZLease from our bulk import template.

Journal entries - First month

Account	Debit	Credit
Initial recognition
Current receivable	4,541.16
Long-term receivable	51,494.01
Unguaranteed residual asset	5,964.83
Initial direct costs expense	2,000.00
Owned assets		54,000.00
Sales profit		8,000.00
Cash expended on initial direct cost (IDC)		2,000.00
Payment received for the first month
Cash rent payment	1,000.00
Current receivable		1,000.00
Interest income recognized for the first month
Unguaranteed residual asset	75.65
Accrued Interest (this will be paid next month)	697.97
Interest income		773.62
Reclassification of lease receivable from long-term to current
Current receivable	346.94
Long-term receivable		346.94

Journal entries - Second month

Account	Debit	Credit
Payment received for the second month
Cash rent payment	1,000.00
Current receivable		302.03
Accrued interest		697.97
Interest income recognized for the second month
Accrued interest	694.15
Unguaranteed residual asset	76.61
Interest income		770.76
Reclassification of lease receivable from long-term to current
Current receivable	351.33
Long-term receivable		351.33

Each month, the lease payments will be booked in the manner shown above, and interest income will be recognized for the net investment (lease receivable and unguaranteed residual asset). At the end of the lease, we will reclassify the net investment in the lease equal to the estimated residual value of the underlying asset of $20,000, as “copier” (physical property, plant & equipment (PP&E) asset).

Journal entries at the end of the lease for reclassification of net investment for copier

Account	Debit	Credit
Reclassification entry at the end of the lease
Copier (New asset on termination)	20,000.00
Unguaranteed residual asset		20,000.00

To enter this lease in EZLease, follow these steps:

Enter a Lease Number or name
Enter the Begin Date as January 1, 2024
Double-click on the Base Term;
in the box that appears, enter 96.
If not already displayed, click on the Main data tab, and in the Rent Steps grid, enter Gross Rent of 1,000.
Enter an Economic Life of 144.

Enter Fair Value of Building/Equipment as 62,000.
Enter Cost or carrying amount as 54,000.
Click on Additional data tab and enter the following:
1. Initial direct costs as 2,000.
2. Unguaranteed residual as 20,000.
Click Save Lease. Note that the system automatically classified this as a Sales-type lease and calculates the rate implicit in the lease as 15.219%.