When a lessor enters a sales-type capital lease, several journal entries will be made to account for the transaction:

• An investment in lease asset is created on the balance sheet (NOTE: this value is greater than the reduction to inventory, so the lessor’s assets on the balance sheet have grown as a result of the transaction).
• A cost of goods sold expense is calculated and recognized (NOTE: COGS is netted against sales revenue to determine gross profit or loss on the “sale”).
• Sales revenue is recognized.
• The inventory asset account on the balance sheet is reduced.

Cash Flows for Lessor’s with Sales-Type Capital Leases

NOTE: local accounting regulations may vary in treatment of these cash flows for a sales-type capital lease, so the student is directed to confirm Level II exam treatment in the official curriculum.

• Over the term of the lease, most of the lessee’s payment is applied to reducing the investment in lease asset (as the lessee is fulfilling its financial obligation to repay principal).  The remaining portion of the lessee’s payment is treated as interest income by the lessor.
• At lease signature, it is quite possible that no cash flows occur, however with the sales-type method, the lessor shows the investment in the lease as an investing cash outflow and the gross profit on the sale as an operating cash inflow.
• As the lessee pays the lessor during the lease term, the interest income portion of the payment may be treated as an operating cash inflow and the principal pay-down portion of the lessee’s payment may be treated as an investing cash inflow.