TopNotch Medical, Inc., is a supplier of medical equipment. It recently introduced a new line of equipment that may revolutionize the medical profession. Because of the new technology, potential users of the equipment are reluctant to purchase the equipment, but they are willing to enter into a lease arrangement if they can classify the lease as an operating lease. The new equipment will replace equipment that TopNotch has been selling in the past. Leasing the new equipment will result in losing an estimated 25% in equipment sales.

Some members of management want to structure the leases so that TopNotch, as lessor, can classify the lease as a sales-type lease and thus avoid further reduction of income. Others believe that they should treat the leases as operating leases and minimize the income tax liability in the short term. They are uncertain, however, as to how the financial statements would be affected under these two different approaches. They also are uncertain as to how leases could be structured to permit the lessee to treat the lease as an operating lease and the lessor to treat it as a sales-type lease. As the accountant for TopNotch, explain how TopNotch should record the leases. Be sure to support your rationale.