Finance Lease vs. Operating Lease: Revenue Recognition and Journal Entries
In a lease (a contract in which you let someone use an asset and receive payments for it), the lessor receives the same cash either way. The difference between the two lease types is how that cash is recorded in the books (the journal entry). We follow a 36-month example with monthly payments.
Looking at the lessor’s books
This page explains the lessor’s accounting (the company that leases out the asset). Accounting is the set of rules for recording transactions, and a lessor’s books have two main parts.
- Statement of financial position (balance sheet: shows what the company owns and owes): for a finance lease, a receivable (the net investment in the lease) is recorded; for an operating lease, the vehicle stays on the books as an asset.
- Statement of profit or loss (income statement: shows income earned and costs incurred): a finance lease shows finance income; an operating lease shows lease income and depreciation.
Tax rules can differ from accounting rules and are not covered on this page.
Example assumptions
- The lessor buys a $100,000 vehicle and leases it to a customer for 36 months.
- Annual interest rate of 12% (1% per month), with level payments (the same amount every month, covering both interest and principal).
- Monthly lease payment = $3,321, so 36 payments total $119,556. Total profit is $19,556.
- All amounts are truncated (rounded down). The monthly lease payment, monthly interest, principal, and depreciation are all calculated in $1 units. In the last payment, any remaining balance is cleared so that the totals match.
- To keep things simple, deposits, advance payments, and residual value (the value left in the vehicle when the contract ends) are all set to zero.
- Operating lease depreciation is assumed to use the 48-month (4-year) straight-line method (the same amount is expensed every month). Depreciating over a period longer than the lease term (36 months) reflects that lessors often depreciate over about 4 years; the depreciation period varies by lessor. As a result, the vehicle still has a carrying amount at the end of payment 36.
Step 1: Contract start date (buying the car and leasing it out)
Journal entry at the start date
You pay $100,000 for the vehicle and record a receivable (the amount you will collect).
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Receivable (net investment in the lease) | $100,000 | |
| Cash | $100,000 | |
| Total | $100,000 | $100,000 |
Journal entry at the start date
The vehicle is recorded as an asset of the lessor. The lessor continues to own it.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Motor vehicles (subject to operating lease) | $100,000 | |
| Cash | $100,000 | |
| Total | $100,000 | $100,000 |
Step 2: Receiving the monthly lease payment
We show payment 1, payment 2, and the last payment (36). The other payments look the same. All amounts are truncated to the nearest $1.
Payment 1
Receiving the lease payment
Interest = remaining principal $100,000 × 1% = $1,000. The rest is principal collected.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,321 | |
| Receivable (net investment in the lease) | $2,321 | |
| Finance income | $1,000 | |
| Total | $3,321 | $3,321 |
① Receiving the lease payment
The entire amount received is recorded as income.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,321 | |
| Lease income | $3,321 | |
| Total | $3,321 | $3,321 |
② Depreciation
$100,000 ÷ 48 months = $2,083.33 → truncated to the nearest $1 = $2,083, recorded as an expense.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Depreciation | $2,083 | |
| Accumulated depreciation | $2,083 | |
| Total | $2,083 | $2,083 |
Payment 2
Receiving the lease payment
Interest = remaining principal $97,679 × 1% = $976.79 → truncated to $976. As the principal falls, so does the interest.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,321 | |
| Receivable (net investment in the lease) | $2,345 | |
| Finance income | $976 | |
| Total | $3,321 | $3,321 |
① Receiving the lease payment
Same as payment 1.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,321 | |
| Lease income | $3,321 | |
| Total | $3,321 | $3,321 |
② Depreciation
Same as payment 1.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Depreciation | $2,083 | |
| Accumulated depreciation | $2,083 | |
| Total | $2,083 | $2,083 |
Payment 36 (last)
Receiving the lease payment
The remaining principal of $3,287 is collected in full. The last interest amount is set to $34 (the lease payment minus the principal) so the totals match. The receivable balance afterward is $0.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,321 | |
| Receivable (net investment in the lease) | $3,287 | |
| Finance income | $34 | |
| Total | $3,321 | $3,321 |
① Receiving the lease payment
Same again.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,321 | |
| Lease income | $3,321 | |
| Total | $3,321 | $3,321 |
② Depreciation
The same $2,083 is depreciated as in payment 1. Only 36 of the 48 depreciation months have passed, so a carrying amount of $25,012 remains on the vehicle. That amount is settled as a gain or loss on derecognition when the vehicle is sold (see Advanced 1 below).
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Depreciation | $2,083 | |
| Accumulated depreciation | $2,083 | |
| Total | $2,083 | $2,083 |
Step 3: Comparing monthly profit
Inside the finance lease: only the interest is profit
Inside the operating lease: income minus expense is profit
| Year | Finance lease profit | Operating lease profit |
|---|---|---|
| Year 1 (payments 1–12) | $10,410 | $14,856 |
| Year 2 (payments 13–24) | $6,676 | $14,856 |
| Year 3 (payments 25–36) | $2,470 | $14,856 |
| Total | $19,556 | $44,568 |
Show the full 36-payment table
| Payment | Payment received | Finance: finance income | Finance: principal collected | Finance: receivable balance | Operating: depreciation | Operating: profit | Operating: vehicle carrying amount |
|---|---|---|---|---|---|---|---|
| 1 | $3,321 | $1,000 | $2,321 | $97,679 | $2,083 | $1,238 | $97,917 |
| 2 | $3,321 | $976 | $2,345 | $95,334 | $2,083 | $1,238 | $95,834 |
| 3 | $3,321 | $953 | $2,368 | $92,966 | $2,083 | $1,238 | $93,751 |
| 4 | $3,321 | $929 | $2,392 | $90,574 | $2,083 | $1,238 | $91,668 |
| 5 | $3,321 | $905 | $2,416 | $88,158 | $2,083 | $1,238 | $89,585 |
| 6 | $3,321 | $881 | $2,440 | $85,718 | $2,083 | $1,238 | $87,502 |
| 7 | $3,321 | $857 | $2,464 | $83,254 | $2,083 | $1,238 | $85,419 |
| 8 | $3,321 | $832 | $2,489 | $80,765 | $2,083 | $1,238 | $83,336 |
| 9 | $3,321 | $807 | $2,514 | $78,251 | $2,083 | $1,238 | $81,253 |
| 10 | $3,321 | $782 | $2,539 | $75,712 | $2,083 | $1,238 | $79,170 |
| 11 | $3,321 | $757 | $2,564 | $73,148 | $2,083 | $1,238 | $77,087 |
| 12 | $3,321 | $731 | $2,590 | $70,558 | $2,083 | $1,238 | $75,004 |
| 13 | $3,321 | $705 | $2,616 | $67,942 | $2,083 | $1,238 | $72,921 |
| 14 | $3,321 | $679 | $2,642 | $65,300 | $2,083 | $1,238 | $70,838 |
| 15 | $3,321 | $653 | $2,668 | $62,632 | $2,083 | $1,238 | $68,755 |
| 16 | $3,321 | $626 | $2,695 | $59,937 | $2,083 | $1,238 | $66,672 |
| 17 | $3,321 | $599 | $2,722 | $57,215 | $2,083 | $1,238 | $64,589 |
| 18 | $3,321 | $572 | $2,749 | $54,466 | $2,083 | $1,238 | $62,506 |
| 19 | $3,321 | $544 | $2,777 | $51,689 | $2,083 | $1,238 | $60,423 |
| 20 | $3,321 | $516 | $2,805 | $48,884 | $2,083 | $1,238 | $58,340 |
| 21 | $3,321 | $488 | $2,833 | $46,051 | $2,083 | $1,238 | $56,257 |
| 22 | $3,321 | $460 | $2,861 | $43,190 | $2,083 | $1,238 | $54,174 |
| 23 | $3,321 | $431 | $2,890 | $40,300 | $2,083 | $1,238 | $52,091 |
| 24 | $3,321 | $403 | $2,918 | $37,382 | $2,083 | $1,238 | $50,008 |
| 25 | $3,321 | $373 | $2,948 | $34,434 | $2,083 | $1,238 | $47,925 |
| 26 | $3,321 | $344 | $2,977 | $31,457 | $2,083 | $1,238 | $45,842 |
| 27 | $3,321 | $314 | $3,007 | $28,450 | $2,083 | $1,238 | $43,759 |
| 28 | $3,321 | $284 | $3,037 | $25,413 | $2,083 | $1,238 | $41,676 |
| 29 | $3,321 | $254 | $3,067 | $22,346 | $2,083 | $1,238 | $39,593 |
| 30 | $3,321 | $223 | $3,098 | $19,248 | $2,083 | $1,238 | $37,510 |
| 31 | $3,321 | $192 | $3,129 | $16,119 | $2,083 | $1,238 | $35,427 |
| 32 | $3,321 | $161 | $3,160 | $12,959 | $2,083 | $1,238 | $33,344 |
| 33 | $3,321 | $129 | $3,192 | $9,767 | $2,083 | $1,238 | $31,261 |
| 34 | $3,321 | $97 | $3,224 | $6,543 | $2,083 | $1,238 | $29,178 |
| 35 | $3,321 | $65 | $3,256 | $3,287 | $2,083 | $1,238 | $27,095 |
| 36 | $3,321 | $34 | $3,287 | $0 | $2,083 | $1,238 | $25,012 |
| Total | $119,556 | $19,556 | $100,000 | $74,988 | $44,568 |
Side-by-side comparison
| Item | Finance lease | Operating lease |
|---|---|---|
| Asset on the statement of financial position | Receivable (the amount to be collected). Shrinks every month | Vehicle. The carrying amount falls with depreciation |
| When a lease payment is received | Cash up / receivable down + finance income | Cash up / lease income |
| Expense | None | Depreciation |
| Shape of profit | Large at first, then shrinks | The same every month under straight-line depreciation |
| Values to store when developing | Interest, principal, receivable balance | Lease income, depreciation, carrying amount |
The shape of operating lease profit changes with the depreciation method
The basic example showed only the straight-line method. Here we compare three ways of spreading depreciation for an operating lease: straight-line, diminishing balance, and the principal-matching method (원금상환비례법; a descriptive label, not a standard term). Changing the method changes how profit is split across years. This section uses a 15% annual rate, so the rate and the numbers differ from the basic example (12%).
Advanced example assumptions
- Cost of $100,000, 15% annual rate, 36-month lease, monthly lease payment $3,466 (36 payments total $124,776), total profit over the lease term of $24,776
- Straight-line and diminishing balance are calculated over 4 years (48 months), which is common in practice. Lessors often depreciate over about 4 years, and the useful life (the depreciation period) varies by lessor. This is the same 48 months as the straight-line method in the basic example (only the interest rate differs).
- The diminishing balance method uses a depreciation rate of 0.528 for a 4-year life. The depreciation rate varies by lessor. 0.528 means 52.8% per year; the monthly depreciation is that rate divided by 12, multiplied by the carrying amount on the first day of the year.
- The principal-matching method uses the lease term (36 months). That is because the principal repaid under the finance lease is used directly as depreciation (this method has no standard English name; “principal-matching” is a descriptive label). We also assume no accrued-income adjustment for operating lease payments: income that is earned but not yet received is not calculated separately, and each month’s lease payment is recorded as that month’s income as is.
- When the lease ends, the vehicle is sold and settled; for illustration, the sale price is assumed to be $30,000.
- Each payment is compared with the same payment number: payment 1 profit with payment 1 interest, payment 2 profit with payment 2 interest, and so on.
Only interest is profit. Shown as a baseline for comparison.
Depreciation is the same amount every month for 48 months.
The annual rate of 0.528 (52.8%) divided by 12 is applied to the carrying amount on the first day of the year. The amount is the same each month within a year, and is recalculated on the reduced carrying amount when the year changes. So depreciation is large at first and then declines.
Depreciation is set equal to the principal repaid under the finance lease. Profit is then exactly the same as the finance lease every month.
Depreciation formulas
The three methods differ only in the formula for “that month’s depreciation.” Under every method, profit is lease income − depreciation.
| Method | Monthly depreciation formula | Payment 1 calculation (truncated to the nearest $1) |
|---|---|---|
| Straight-line | Cost ÷ number of depreciation months | $100,000 ÷ 48 = $2,083.33 → $2,083 |
| Diminishing balance | Carrying amount on the first day of the year × depreciation rate ÷ 12 (the same amount every month within a year) | $100,000 × 0.528 ÷ 12 = $4,400 → $4,400 |
| Principal-matching method | The finance lease principal repaid that month = monthly lease payment − interest (interest = remaining principal × annual rate ÷ 12) | Interest $100,000 × 15% ÷ 12 = $1,250 $3,466 − $1,250 = $2,216 |
In the diminishing balance method, the carrying amount shrinks each year, so monthly depreciation shrinks too
| Diminishing balance year | Carrying amount on the first day of the year | Monthly depreciation | Monthly lease income | Monthly profit |
|---|---|---|---|---|
| Year 1 (payments 1–12) | $100,000 | $4,400 | $3,466 | -$934 |
| Year 2 (payments 13–24) | $47,200 | $2,076 | $3,466 | $1,390 |
| Year 3 (payments 25–36) | $22,288 | $980 | $3,466 | $2,486 |
Carrying amount on the first day of next year = carrying amount on the first day of this year − (monthly depreciation × 12). For example, the first day of year 2 is $100,000 − $4,400 × 12 = $47,200. In year 1, depreciation is larger than lease income, so every month is a loss; from year 2 it turns into profit.
Where does 0.528 come from?
The diminishing balance depreciation rate is generally said to be calculated as 1 − (residual value ÷ cost)1 ÷ useful life, where residual value is the value left after use. If the residual value is set to 5% of cost and the useful life to 4 years, the rate is 1 − 0.051/4 = 1 − 0.473 = about 0.527, and rounding up at the third decimal place gives 0.528.
This page uses the rounded-up result above as the depreciation rate. The residual value ratio and the depreciation rate vary by lessor.
Profit by year over the 36-month lease term
| Year | Finance lease | Operating lease, straight-line | Operating lease, diminishing balance | Operating lease, principal-matching method |
|---|---|---|---|---|
| Year 1 (payments 1–12) | $13,087 | $16,596 | -$11,208 | $13,087 |
| Year 2 (payments 13–24) | $8,502 | $16,596 | $16,680 | $8,502 |
| Year 3 (payments 25–36) | $3,187 | $16,596 | $29,832 | $3,187 |
| 36-month total | $24,776 | $49,788 | $35,304 | $24,776 |
Inside the three operating lease methods (48 months)
The three charts use the same scale ($0 to $60,000). The gap between the dark solid line (lease income) and the dashed line (depreciation) is that month’s profit (blue) or loss (red). The horizontal axis covers the 48 depreciation months of the straight-line and diminishing balance methods; lease income occurs only through payment 36.
Straight-line (48 months): the same amount every month
Diminishing balance (48 months): large at first, then smaller
Principal-matching method (36 months): depreciate by the finance lease principal repaid
After the lease ends: the remaining carrying amount is settled as a gain or loss on derecognition
Straight-line and diminishing balance spread depreciation over 48 months, so a carrying amount remains on the vehicle even when the lease ends at payment 36. This is not an error. When the vehicle is sold, the difference between the sale price and the carrying amount is recorded as a gain or loss on derecognition (the profit or loss that arises when an asset is sold).
| Method | 36-month profit total | Carrying amount at payment 36 | Gain or loss on derecognition (assuming a sale price of $30,000) | Final total |
|---|---|---|---|---|
| Straight-line (48 months) | $49,788 | $25,012 | $4,988 | $54,776 |
| Diminishing balance (48 months) | $35,304 | $10,528 | $19,472 | $54,776 |
| Principal-matching method (36 months) | $24,776 | $0 | $30,000 | $54,776 |
The sale price of $30,000 is an assumed value for illustration. Whatever the sale price, the final totals of the three methods are the same, because final total = total of the 36 lease payments $124,776 + sale price − cost $100,000 = $54,776. The depreciation method changes only when profit is recognized. The diminishing balance method depreciates more early, leaving a smaller carrying amount and a larger gain on sale; straight-line leaves a larger carrying amount and a smaller gain.
“리스회사가 운용리스자산에 대해 정률법등을 적용하여 상각하는 경우 리스기간 초기에 감가상각액이 운용리스료 수익을 초과함으로써 손실이 발생할 수 있다. 이 경우 감가상각비를 고려하여 당해 리스자산으로 인한 이익을 기간별로 균등하게 하는 방법으로 수익을 인식할 수 있다.” (리스회계처리준칙 6-2)
In journal entries, only the depreciation amount differs
The journal entry for receiving the payment in payment 1 is the same under every method; only the depreciation amount differs.
① Receiving the lease payment
Same under all three methods.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,466 | |
| Lease income | $3,466 | |
| Total | $3,466 | $3,466 |
② Depreciation
$100,000 ÷ 48 months = $2,083.33 → truncated to $2,083. It is smaller than the lease income, so there is a profit.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Depreciation | $2,083 | |
| Accumulated depreciation | $2,083 | |
| Total | $2,083 | $2,083 |
① Receiving the lease payment
Same under all three methods.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,466 | |
| Lease income | $3,466 | |
| Total | $3,466 | $3,466 |
② Depreciation
$100,000 × 0.528 ÷ 12 = $4,400. It is larger than the lease income, so this month is a loss.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Depreciation | $4,400 | |
| Accumulated depreciation | $4,400 | |
| Total | $4,400 | $4,400 |
① Receiving the lease payment
Same under all three methods.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $3,466 | |
| Lease income | $3,466 | |
| Total | $3,466 | $3,466 |
② Depreciation
Depreciation equals the finance lease principal repaid in payment 1. The remaining profit equals the interest of $1,250.
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Depreciation | $2,216 | |
| Accumulated depreciation | $2,216 | |
| Total | $2,216 | $2,216 |
Journal entry when the vehicle is sold after the lease ends
When the 36-month lease ends, the lessor sells the returned vehicle as a used car. A journal entry is needed to remove the vehicle from the books. Follow the steps below and it is not hard.
Two terms first
- Accumulated depreciation: the running total of the monthly depreciation expense. For example, if you depreciated $2,083 a month for 36 months, accumulated depreciation is $2,083 × 36 = $74,988. The vehicle asset itself stays at $100,000, and the amount written down is accumulated separately in this account.
- Carrying amount: the current value of the vehicle as recorded in the books (also called book value).
carrying amount = vehicle cost − accumulated depreciation; for straight-line, $100,000 − $74,988 = $25,012.
3 things to do when the vehicle is sold
- Record the money received. The vehicle sold for $30,000 in cash, so debit Cash.
- Remove the vehicle from the books. The vehicle no longer belongs to the company, so credit the vehicle cost of $100,000 to remove it, and debit accumulated depreciation to clear it. Both accounts go to $0.
- Record the remaining difference as a gain or loss on derecognition. If you record only steps 1 and 2, debits and credits do not balance. The difference is exactly the sale price minus the carrying amount, and recording it as a gain (or a loss, if negative) balances the entry.
Straight-line: $30,000 − $25,012 = $4,988
Put simply, the books said “this car is worth about $25,012,” and you sold it for $30,000, so you gained the difference. The larger the carrying amount (the less you have written down), the smaller the gain.
Even if you sell the same car at the same price, the accumulated depreciation differs by depreciation method, so the carrying amount and the gain differ.
Vehicle sale
- This is the same as the $25,012 in the “Carrying amount at payment 36” table above.
- Accumulated depreciation: $2,083 a month for 36 months → $2,083 × 36 = $74,988
- Carrying amount: $100,000 − $74,988 = $25,012
- Gain on derecognition: sold for $30,000, so $30,000 − $25,012 = $4,988
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $30,000 | |
| Accumulated depreciation | $74,988 | |
| Motor vehicles (subject to operating lease) | $100,000 | |
| Gain on derecognition of property, plant and equipment | $4,988 | |
| Total | $104,988 | $104,988 |
Vehicle sale
- This is the same as the $10,528 in the “Carrying amount at payment 36” table above.
- Accumulated depreciation: add up the monthly depreciation from the diminishing balance table above, 12 months per year.
Year 1: $4,400 × 12 = $52,800
Year 2: $2,076 × 12 = $24,912
Year 3: $980 × 12 = $11,760
Total = $89,472 - Carrying amount: $100,000 − $89,472 = $10,528
- Gain on derecognition: $30,000 − $10,528 = $19,472 (a lot was written down, so the gain is large)
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $30,000 | |
| Accumulated depreciation | $89,472 | |
| Motor vehicles (subject to operating lease) | $100,000 | |
| Gain on derecognition of property, plant and equipment | $19,472 | |
| Total | $119,472 | $119,472 |
Vehicle sale
- This is the same as the $0 in the “Carrying amount at payment 36” table above.
- Accumulated depreciation: each month, the principal repaid under the finance lease is recorded as depreciation. Over 36 months the full principal of $100,000 is recovered, so accumulated depreciation is also $100,000.
- Carrying amount: $100,000 − $100,000 = $0
- Gain on derecognition: $30,000 − $0 = $30,000 (the entire sale price is gain)
| Account | Debit (left) | Credit (right) |
|---|---|---|
| Cash | $30,000 | |
| Accumulated depreciation | $100,000 | |
| Motor vehicles (subject to operating lease) | $100,000 | |
| Gain on derecognition of property, plant and equipment | $30,000 | |
| Total | $130,000 | $130,000 |
- Varies by lessor: account names, depreciation period and method, truncation method, and gain/loss treatment. Account names on this page use IFRS terms (IFRS 16, IAS 16) where they exist; actual account names differ by company.
- Example numbers: Made up to aid understanding; not actual contract values. Journal entries and numbers are simplified to show the concept.
- Truncation: All amounts are truncated (rounded down) to the nearest $1.
- Depreciation period: Operating lease straight-line is 48 months in both the basic example and Advanced 1; diminishing balance in Advanced 1 is also 48 months; the principal-matching method is 36 months.
- Interest rate: The basic example uses 12% per year and Advanced 1 uses 15% per year.