INTERMEDIATE ACCOUNTING 2

CLASSIFICATION OF FINANCE LEASE BY THE LESSOR

A lessor classifies a finance lease as either:

a. direct financing lease

b. sales type lease

DIRECT FINANCING LEASE

underlying a direct financing lease, a lessor acquires assets and leases them the intention of
generating income through interest. The lessor is neither the manufacturer nor a dealer of the asset
being leased. The previous illustrations pertain to direct financing lease.

ADDITIONAL EXPLANATION:

A direct financing lease is a type of lease arrangement in which a lessor (the owner of an asset)
provides financing to a lessee (the user of the asset) for the acquisition of the asset. In a direct financing
lease, the lessor acts as a lender, while the lessee assumes the role of the borrower.

Direct financing leases provide businesses with an alternative method of acquiring assets
without incurring the upfront cost of purchase. They can be beneficial for lessees who require
the use of an asset but prefer not to tie up significant capital in ownership. For lessors, direct
financing leases offer an opportunity to generate income through interest payments and lease
arrangements.

SALES TYPE LEASE

Under a sales type lease, the lessor is the manufacturer or a dealer of the asset being leased and uses
leasing as a means of marketing its products. The lessor often provides its customers a choice if either
buying or leasing an asset.

ADDITIONAL EXPLANATION:

A sales-type lease is a type of lease arrangement that combines elements of both a lease
and a sale. It is a financial arrangement where the lessor (the owner of an asset) effectively sells
the asset to the lessee (the user of the asset) and simultaneously provides financing for the
purchase.

Sales-type leases are commonly used in situations where the lessor is primarily in the
business of leasing assets and providing financing. This type of lease allows the lessor to earn a
profit by combining the sale of the asset with lease financing. For the lessee, a sales-type lease
offers the advantage of acquiring the asset without a substantial upfront payment, spreading
the cost over the lease term.

A sales type lease is accounted for like a direct financing lease, except that the manufacturer or dealer
lessor recognizes the following at the commencement date:
a. sales revenue – also known as sales or net sales, refers to the total amount of money
generated by a company through the sale of its goods or services during a specific period. It
represents the primary source of income for businesses engaged in the sale of products or
services, measured at the lower of the;

i. present value of lease payments, discounted using a market rate of interest

- The present value of lease payments, discounted using a market rate of

interest, refers to the current value of the future lease payments expected
to be received or made, adjusted for the time value of money. It involves
discounting the future cash flows associated with the lease to their
present value using an appropriate discount rate.

ii. fair value of the asset

- The fair value of an asset refers to the estimated value at which the asset
would be exchanged between knowledgeable and willing parties in an
arm's length transaction. It represents the price that would be received to
sell an asset or the price that would be paid to transfer a liability in an
orderly transaction in the market at a specific point in time.

b. cost of sale – equal to the cost, or carrying amount if different, of the underlying asset less the
present value of the unguaranteed residual value

ADDITIONAL EXPLANATION: The cost of sales, also known as the cost of goods sold (COGS),
refers to the direct costs incurred by a company to produce or acquire the goods or services
it sells. It represents the expenses directly associated with the production or procurement of
goods or services that are subsequently sold to customers.

c. gross profit – the difference between revenue and cost of sales

ADDITIONAL EXPLANATION: Gross profit refers to the amount of revenue or sales left after
deducting the direct cost of producing or acquiring the goods or services sold. It represents
the profit earned by a company before accounting for operating expenses, interest, taxes,
and other non-operating expenses.