What is the difference between sales type leases and direct financing leases

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Stock Advisor will renew at the then current list price. Investing Best Accounts. Stock Market Basics. Stock Market. Industries to Invest In. Getting Started. When a lessor leases property under a sale type lease, for instance, the lessor hopes to earn profit on the property in addition to any money earned on interest. In a direct financing lease, the lessor only earns a profit on interest, charging payment amounts that directly equate to the value of the property in question.

At the inception of a direct sales lease, the lessor creates a journal entry that debits, or records the profit of, all future lease payments while crediting, or recording the loss of, leased assets property and unearned interest revenue, or any difference between the total lease payment amount and the value of the asset. The lessor subsequently records each payment on the lease as a debit, including all interest earned.

When a lessor provides a sales type lease, journal entries debit the value of lease payments and the value of the asset, because the lessee assumes liability for the asset, and credits unearned interest and the loss of sale value and inventory incurred by leasing the property. When a lessee takes on a capital lease it records the asset, or property, in question as an acquisition, or debit, because the lessee assumes liability for, and therefore temporary ownership rights to, the leased property.

The lessee of a direct financing lease records payments made against the value of the property and interest paid as credits. When a lessee takes on a direct sales lease, that company or individual makes no amortized payments, or payments against the value of an asset, but only payments for the use of the asset, recorded as credits. Unlike sales type leases, direct financing leases do not allow lessees to record the property in question as an asset, as the lessor retains liability.

In a direct-finance lease, the carrying amount of the lease equals the fair market value of the leased asset. Therefore, the transaction does not result in a gain or loss, only interest revenue for the lessor.

The lessor records the entry as a sale, removing the asset from its books and creating a receivable for the interest payments. The lessor determines the interest rate by calculating the internal rate of return for the asset.

In contrast to a direct-finance lease, a sales-type lease provides the dealer with a profit on the sale of the asset in addition to interest revenue earned. The profit derives from the difference between the fair value of the asset, or selling price, and the carrying value of the asset sold.

The lessor uses the same accounting treatment as a direct-finance lease; however, profit is recognized at the inception of the lease. Which lease type works the best for you will depend on the nature of your small business. Companies that engage in direct financing often acquire assets with a plan to use the equipment to generate enough income to cover the lease payments as well as turn a profit.