Businesses sometimes find that they have more physical assets than they need. They may sell these assets or lease them to other companies. Leasing provides additional revenue for the business who wants to continue owning a property for awhile. When the business leases the property, the customer may pay for a longer time frame than the current month up front. The revenue received for future periods has not been earned and represents unearned revenue.
Types Of Leases
Businesses engage in three types of leases. These include sales-type leases, direct financing leases and operating leases. Each type of lease requires specific accounting treatments in the lessor’s financial records. The sales-type lease and direct financing lease both need to include one of the following criteria. These include transferring the property to the lessee at the completion of the lease, a bargain purchase option, a lease term greater than 75 percent of the property’s life or a present value of the lease payments greater than 90 percent of the property’s fair market value. In addition, sales-type leases create a profit or loss for the lessor. A direct financing lease does not create a profit or loss for the lessor. An operating lease includes all leases that do not fit the criteria for a sales-type or direct financing lease.
In a sales-type lease, the lessor removes the property from its financial records when it enters into the lease. The lessor records a receivable in its financial records. Each payment received from the lessee reduces the receivable. The lessor records a gain or loss from the transaction at the time it enters the lease. The company calculates the present value of the lease payments and compares it to the book value of the asset to determine the gain or loss.
Direct Financing Lease
In a direct financing lease, the lessor removes the property from its financial records when it enters into the lease. The lessor records a receivable in its financial records. Each payment received from the lessee reduces the receivable. The lessor does not record any revenue from the transfer of the property or any rent revenue.
In an operating lease, ownership returns to the lessor at the conclusion of the lease. The lessor maintains the financial record of the property in its accounting records and continues to depreciate the property. When the lessor receives the lease payment from the lessee, it records an increase in Unearned Lease Revenue and an increase in Cash. As each month of the lease term passes, the lessor records the revenue earned for that period. It records an increase in Lease Revenue and a decrease in Unearned Lease Revenue.