A lessor must capitalize a lease if any of the four lessee conditions for capitalization are present, PLUS BOTH of the following requirements are met:
- The lessor can reasonably expect to collect the minimum lease payments; and
- The lessor has no material uncertainties regarding the amount of un-reimbursable costs yet to be incurred, as part of the lease agreement.
If these conditions are not met, then the lessor normally must classify the lease as an operating lease. In reality, it is common for the lessor and lessee to use the same accounting treatment for leases.
Lessor Accounting for Operating Leases
Payments received from the lessee are treated as rental revenue on the lessor’s income statement and the lessor continues to account for the leased asset as a fixed asset on its balance sheet.
Lessor Accounting for Capital Leases
There are two types of lessor capital leases:
- Sales-Type Lease: The lessor firm is typically a dealer or manufacturer who leases its equipment rather than selling the equipment outright. Under a sales-type lease, the lessor will recognize a profit or loss on the sale of the leased product and recognize on-going interest income from the capitalized lease over the lifetime of the lease.
- Direct Financing Lease: The lessor firm leases to other companies at cost and the income from the lease is interest income. An example of this business model would be a financial institution that owns an aircraft leasing unit which leases aircrafts to other companies at a rate the covers the cost of the airplane plus interest. The income from the lease is recognized as interest income on the lessor’s income statement, representing the lessor’s return on investment in the capital lease.
Classifying a lease as a capital lease or operating lease by a lessor is a materially significant accounting policy, as the balance sheet, the income statement, the statement of cash flows, and key financial ratios will be different under the different methods.