Accounting For Leases

CFA Level 1 - Liabilities

A lessor (the leasing company) can account for a lease in three ways:

• Operating lease
• Direct-financing lease
• Sales-type lease

Lease capitalization, which includes the direct-financing lease and the sales-type lease, needs to be recognized when a lease meets any one of the four criteria specified for capitalization of leases and both of the following revenues-recognition criteria:

• Collection of the monthly lease payments is reasonably predictable.
• Lessor's performance is substantially complete, or future costs are reasonably predictable.

If the lease is accounted for as a capital lease, the lessor must determine if it classifies as a direct-finance lease or as a sales-type lease. To classify as a sales-type lease, the fair value of the asset must be greater than the lessor's book value. If not, it is accounted for as a direct-financing lease.

Direct-Financing LeaseAs its name implies, a direct-financing lease is basically the coupling of a sale and financing transaction. In this case, the lessor removes the leased asset from its books and replaces it with a receivable from the lessee.
The only income recognized by the lessor is the interest received. The implied rate is taken by calculating IRR of the asset; cash inflow is equal to lease payments and cash outflow is equal to the book value of the lease asset.
Sales-Type LeaseA sales-type lease is accounted for like a direct-financing lease, except that profit on a sale is recognized upon inception of the lease, in addition to the interest income recognized during the lease term. The gross profit recognized at the inception of the lease is the PV of all lease payments minus the cost of the leased asset.

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