TopNotch Medical, Inc., is a supplier of medical equipment. It recently introduc

Question

TopNotch Medical, Inc., is a supplier of medical equipment. It recently introduced a new line of equipment that may revolutionize the medical profession. Because of the new technology, potential users of the equipment are reluctant to purchase the equipment, but they are willing to enter into a lease arrangement if they can classify the lease as an operating lease. The new equipment will replace equipment that TopNotch has been selling in the past. Leasing the new equipment will result in losing an estimated 25% in equipment sales.

Some members of management want to structure the leases so that TopNotch, as lessor, can classify the lease as a sales-type lease and thus avoid further reduction of income. Others believe that they should treat the leases as operating leases and minimize the income tax liability in the short term. They are uncertain, however, as to how the financial statements would be affected under these two different approaches. They also are uncertain as to how leases could be structured to permit the lessee to treat the lease as an operating lease and the lessor to treat it as a sales-type lease. As the accountant for TopNotch, explain how TopNotch should record the leases. Be sure to support your rationale.

Explanation / Answer

In practice, the difference between a sales type lease and a direct financing lease is pretty minimal. Both types are considered capital leases, meaning the lessor finances the leased asset but all the rights to ownership transfer to the lessee. This is a common financial arrangement for equipment, real estate, and many other asset types.

In the accounting sense, however, the difference between the sales type and the direct financing type are quite different.

Accounting for a direct financing lease
In a direct financing lease, the lessor accounts for the income from the sale over time as the lease payments are made. When the asset is leased, the lessor removes the asset's book value from its balance sheet and replaces it with a receivable equal to the book value. The internal rate of return on the asset -- the difference in cash flows from all the monthly payments less the book value of the asset when it was sold -- is used as the implied interest rate for the lease.

This arrangement is analogous to how a bank would account for a loan. Each month, the loan payment is paid, and the bank recognizes the interest portion of the payment as income and the principal portion goes to reduce the loan's balance.

As each payment is received in the direct financing lease arrangement, the lessor records income based on the implied interest portion based on the asset's internal rate of return and the remainder would be netted from the receivable on its balance sheet set up for each direct financed lease. The accounts are different, but the mechanism is very similar to the bank example.

Accounting for a sales type lease
While the direct financing accounting recognizes income over time as payments come in, the sales type lease accounts for a portion of that income immediately upon the inception of the lease, with the remainder accounted for over the term of the lease.

The lessor should recognize the gross profit from the lease immediately upon the start of the lease. The gross profit is calculated as the present value of the future cash flow from the lease less the book value of the asset at the start of the lease, discounted at the implied internal rate of return. The remaining value of the lease is then accounted for like the direct financing type as payments are received over time.

The sales type lease, therefore, allows the lessor to recognize more revenue at lease inception, while the direct financing arrangement recognizes no revenue up front but then catches up as the lease progresses.

In both cases, the lessee should carry the asset on its balance sheet as a fixed asset. The lessor no longer shows the asset on its balance sheet, but instead will show the value of the financing agreement as a receivable

Depreciation for Lessor in Direct Financing Leases

The lessor in a direct financing lease owns the asset and, therefore, may depreciate it. This means a portion of the value of the asset is deducted from taxable income for each year of the life of the asset. Determine the useful life of the asset by contacting the manufacturer.

Interest Income from Direct Financing Leases

The lessor lists the interest from a direct financing lease as unearned income. This income should be included under "gross income" on line 1 of Internal Revenue Schedule C. You earn this income over the life of the lease.

Expensing Leasing Costs

The lessor can deduct any expenses for the lease in the year they occur. These can include shipping and warehousing the asset, as well as travel to the client to negotiate the terms of the lease. Accounting fees and legal fees for creating the lease may also be deducted in the year they occur.

Who Offers a Sales-Type Lease?

Manufacturers and dealers of a product offer sales-type leases. The item is assumed to have been sold in the year the lease begins. Interest will accrue to the lessor during the term of a sales-type lease.

Depreciation for Lessee in Sales-Type Lease

The lessee, not the lessor, depreciates the asset in a sales-type lease. The lessor is assumed to have purchased the asset, even though the agreement is called a lease. The Internal Revenue Service is particularly diligent about this issue when the lease lasts for the lifetime of the asset. The IRS treats this as a sale.

Income from a Sales-Type Lease

The lessor counts lease payments as unearned income, but may show an inventory cost in the year it enters into the lease. This inventory cost is the value of the asset at the beginning of the lease. This inventory cost may be deducted from the income from the lease.

Indirect Expenses for a Sales-Type Lease

Any expenses the lessor incurs for a sales-type lease may be deducted in the year they occur. These may include shipping and warehousing, as well as accounting and legal fees associated with the lease.

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