9.2 Lease Classification

ASC 842-10

25-1 An entity shall classify each separate lease component at the commencement date. An entity shall not reassess the lease classification after the commencement date unless the contract is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8. . . .

The five criteria that a lessor uses to determine whether a lease is a sales-type lease are the same as those that a lessee uses to establish whether a lease is a finance lease. If none of those criteria are met, the lessor evaluates whether the lease is a direct financing lease; two criteria must be met for the lease to be considered a direct financing lease. If neither the sales-type lease criteria nor the direct financing lease criteria are met, the lease is an operating lease. In addition, because of the amendments in ASU 2021-05, even a lease that meets one of the five criteria to be a sales-type lease (or is classified as a direct financing lease) should be classified as an operating lease when the lessor would have recognized a selling loss and the arrangement includes variable lease payments that do not depend on an index or a rate. A lessor performs its lease classification assessment at lease commencement (i.e., when the lessee obtains the right to use the asset).

The decision tree below illustrates the lessor’s classification assessment as well as the criteria that must be met for each type of lease.

Changing Lanes

Classification Date

Unlike ASC 842, ASC 840 required entities to classify leases on the basis of the facts and circumstances present at lease inception (i.e., the date of the lease agreement or commitment, if earlier) instead of at lease commencement (the date on which the lessor makes an underlying asset available to the lessee). For many entities, there typically is not a significant lag between lease inception and lease commencement; however, in certain circumstances, the two dates significantly differ. In such cases, a lessor could theoretically arrive at different conclusions if facts and circumstances change between the dates (e.g., the fair value of the underlying asset or the rate implicit in the lease). The diagram below illustrates the difference between lease inception and lease commencement.

Leveraged Leases

ASC 840 addressed a fourth type of lease, a leveraged lease. Leveraged lease accounting was a special type of accounting that a lessor employed for certain direct financing leases. Special accounting was required for a leveraged lease because of the unique economic effect on the lessor. This unique economic effect stemmed from a combination of nonrecourse financing and a cash flow pattern that typically enabled the lessor to recover its investment in the early years of the lease (as a result of tax benefits generated by depreciation, interest, and ITC deductions) and subsequently afforded it the temporary use of funds from which additional income could be derived.

The FASB did not include leveraged leases in the guidance in ASC 842 on lease classification. In the Background Information and Basis for Conclusions of ASU 2016-02, the FASB addresses why it decided not to retain leveraged leases in the new leasing model, indicating that some Board members objected to the net presentation related to leveraged leases and others believed that the accounting for such leases was too complex. However, the Board decided to grandfather in existing leveraged leases given that “there would be significant complexities relating to unwinding existing leveraged leases” during transition. Therefore, a lessor must continue to apply the accounting in ASC 840 for such a lease (as carried forward in ASC 842) and classify the lease as a leveraged lease provided that it enters into the lease before the effective date of ASC 842. See Section 9.5 for more information about how to account for grandfathered leveraged leases.

Bridging the GAAP

IFRS 16 Does Not Distinguish Between Sales-Type and Direct Financing Leases

Unlike ASC 842, IFRS 16 does not differentiate sales-type leases from direct financing leases. Rather, lessors account for leases as either operating or finance leases. See Appendix B for a summary of the differences between ASC 842 and IFRS 16.

9.2.1 Sales-Type Lease

In a sales-type lease, the lessor transfers control of the underlying asset to the lessee. In paragraph BC93 of ASU 2016-02, the FASB acknowledges that “[e]ven though a sales-type lease is not necessarily identical to a sale, the transactions are economically similar (for example, because sales-type lessors often use leasing as an alternative means to sell their assets and have no intention of reusing or re-leasing assets leased under a sales-type lease).” Paragraph BC93 of ASU 2016-02 further points out that the hallmark of a sales-type lease is the recognition of “selling profit at lease commencement” and that such recognition “is consistent with the principle of a sale in Topics 606 and 610.”

Changing Lanes

Sales-Type Leases Affected by Shift From Risks-and-Rewards Model to Control Model

A sales-type lease results in the recognition of profit (or loss). Therefore, to be consistent with ASC 606, the FASB decided to align the transfer-of-control notion, as it applies to the evaluation of whether a lease qualifies as a sales-type lease, with that in ASC 606. In paragraph BC121 of ASU 2014-09, the Board observes:

[T]he assessment of when control has transferred could be applied from the perspective of either the entity selling the good or service or the customer purchasing the good or service. Consequently, revenue could be recognized when the seller surrenders control of a good or service or when the customer obtains control of that good or service. Although in many cases both perspectives lead to the same result, the Boards decided that control should be assessed primarily from the perspective of the customer. That perspective minimizes the risk of an entity recognizing revenue from undertaking activities that do not coincide with the transfer of goods or services to the customer.

The evaluation of whether a lease qualifies as a sales-type lease therefore focuses on whether the lessee effectively obtains control of the entire underlying asset (i.e., and not just the right to use it) rather than whether the lessor has relinquished control. Accordingly, an arrangement that a lessor historically classified as a sales-type lease because it transferred a portion of the risks and rewards of the underlying asset to the lessee and a portion to a third party through a residual value guarantee (e.g., residual value insurance) may no longer qualify as a sales-type lease.

ASC 842-10

25-2 [A] lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

25-3A Notwithstanding the requirements in paragraphs 842-10-25-2 through 25-3, a lessor shall classify a lease with variable lease payments that do not depend on an index or a rate as an operating lease at lease commencement if classifying the lease as a sales-type lease or a direct financing lease would result in the recognition of a selling loss.

25-7 See paragraphs 842-10-55-2 through 55-15 for implementation guidance on lease classification.

The criteria in ASC 842-10-25-2 for a lessor’s sales-type lease classification are identical to the criteria lessees use to identify a finance lease. (See Section 8.1 for a discussion of the lessee’s classification.) Therefore, the lessee’s classification will often be similar to the lessor’s; however, as further discussed below, there are differences between the two, such as leases with a day 1 selling loss for the lessor or differences in the assumptions (e.g., residual asset value) or discount rate used (rate implicit in the lease for the lessor and the incremental borrowing rate for the lessee).

Connecting the Dots

Sales-Type Leases for Real Estate

Because a lease may qualify as a sales-type lease without a title transfer under ASC 842, more leases will qualify for sales-type classification. ASC 842 does not distinguish between the accounting for real estate and that for non–real estate. In paragraph BC99 of ASU 2016-02, the FASB states, in part:

Previous GAAP included different lessor requirements for leases of real estate (for example, a lease of real estate could only be a sales-type lease if it transferred title to the real estate to the lessee by the end of the lease term) because the revenue requirements in previous GAAP for the sale of real estate differed from the revenue requirements in previous GAAP applicable to the sale of other assets. The creation of Topic 606 eliminated those different revenue accounting requirements; therefore, there is no longer a reason for the accounting for leases of real estate to differ from the accounting for leases of other assets.

Real Estate Lessors Must Perform Classification Test

Since ASC 842 does not distinguish between real estate leases and non–real estate leases and does not require that title transfer occur before a sales-type lease is recognized, real estate lessors will need to evaluate whether leases meet the criteria for classification as a sales-type lease.

Collectibility Does Not Affect Classification as Sales-Type Lease

While collectibility affects recognition related to sales-type leases under ASC 842 (discussed in Section 9.3.7.2), ASC 842 does not address collectibility with respect to the classification of such leases. Therefore, because the classification criteria in this regard are less strict, more leases will qualify as sales-type leases than under previous guidance.

9.2.1.1 Transfer of Ownership at the End of the Lease Term — ASC 842-10-25-2(a)

ASC 842-10

55-4 The criterion in paragraph 842-10-25-2(a) is met in leases that provide, upon the lessee’s performance in accordance with the terms of the lease, that the lessor should execute and deliver to the lessee such documents (including, if applicable, a bill of sale) as may be required to release the underlying asset from the lease and to transfer ownership to the lessee.

55-5 The criterion in paragraph 842-10-25-2(a) also is met in situations in which the lease requires the payment by the lessee of a nominal amount (for example, the minimum fee required by the statutory regulation to transfer ownership) in connection with the transfer of ownership.

55-6 A provision in a lease that ownership of the underlying asset is not transferred to the lessee if the lessee elects not to pay the specified fee (whether nominal or otherwise) to complete the transfer is an option to purchase the underlying asset. Such a provision does not satisfy the transfer-of-ownership criterion in paragraph 842-10-25-2(a).

If the lease transfers ownership, such as through the transfer of title at or shortly after the end of the lease term, the above criterion in ASC 842-10-25-2(a) would be met. In substance, such a transaction is akin to a financed purchase (i.e., the asset was purchased and financed through lease payments). If the lessee is required to pay a nominal fee for title transfer, the lease would meet the criterion in ASC 842-10-25-2(a). If paying the fee (even in circumstances in which the fee is nominal) is optional, the lease would not meet this criterion, although the lease should be evaluated under the “reasonably certain purchase option” criterion in ASC 842-10-25-2(b); see further discussion in the next section.

9.2.1.2 Purchase Option Reasonably Certain to Be Exercised — ASC 842-10-25-2(b)

As indicated in ASC 842-10-25-2(b), when a “lease grants the lessee an option to purchase the underlying asset,” it must be reasonably certain that the lessee will exercise that option, at which point the lessor is required to classify the lease as a sales-type lease. “Reasonably certain” is a high threshold. A purchase option’s exercise may be reasonably certain for many reasons (e.g., an economic compulsion or incentive for the lessee to exercise its option). See Section 5.2.2 for a discussion of the notion of “reasonably certain.”

ASC 842-10-55-26 includes a list of economic factors (not all-inclusive) for an entity to consider when evaluating whether the exercise of an option is reasonably certain. Such an evaluation must include an assessment of whether an economic compulsion exists.

The examples below demonstrate scenarios in which the lessee’s exercise of its purchase option would be reasonably certain.

Example 9-1

Entity P leases a tractor that it may purchase for $10,000 at the end of the lease term. The fair value of the tractor is expected to be $20,000 when the lease term ends. Further, P has provided the lessor with a residual value guarantee of $25,000 in the event that P does not exercise the purchase option.

Example 9-2

Entity U leases an airplane in which it installs luxury seating and a gold-plated cocktail bar, both of which add significant value to the airplane. At the end of the lease term in three years, U may purchase the airplane for an amount that is commonly paid for an airplane that does not have luxury seating and a cocktail bar. The remaining useful life of the seating and bar assets extends 20 years after the noncancelable lease term.

9.2.1.3 Major Part of the Remaining Economic Life — ASC 842-10-25-2(c)

ASC 842-10

55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph] 842-10-25-2(c) . . . would be to conclude:

Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset. . . .

The ASC master glossary defines economic life as “[e]ither the period over which an asset is expected to be economically usable by one or more users or the number of production or similar units expected to be obtained from an asset by one or more users.” As noted above, if the “lease term is for the major part of the remaining economic life of the underlying asset,” the lease is a sales-type lease; however, if the lease term begins “at or near the end of the economic life of the underlying asset,” the lessor should not use this criterion in its evaluation. (For further discussion, see Section 9.2.1.3.5.)

The lease classification guidance in ASC 842-10-25-2 does not explicitly prescribe bright-line thresholds as part of the economic-life test; therefore, an entity is permitted, but is not required, to assess certain quantitative bright-line thresholds when classifying a lease under ASC 842.

The implementation guidance in ASC 842-10-55-2 further states that a reasonable approach to applying the lease classification criteria in ASC 842 would be the use of certain bright-line thresholds as follows:

When determining lease classification, one reasonable approach to assessing the criteria in paragraphs 842-10-25-2(c) through (d) and 842-10-25-3(b)(1) would be to conclude:

Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.
Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.

On the basis of this implementation guidance, we would not object if an entity were to apply bright-line thresholds when classifying a lease under ASC 842. We would expect that under such an approach, an entity would classify a lease in accordance with the quantitative result. That is, if an entity, as an accounting policy, elects to apply bright-line thresholds and determines that a lease term is equal to 76 percent of an asset’s useful life, the entity should classify the lease as a sales-type lease. The entity should not attempt to overcome the assessment with qualitative evidence to the contrary. Likewise, if the same entity were to determine that a lease term is equal to 74 percent of an asset’s useful life, the entity should classify the lease as an operating lease (provided that other lease classification criteria are not met). We would expect that if an entity were to decide to apply the bright-line thresholds in ASC 840 when classifying a lease, the entity would apply those thresholds consistently to all of its leases.

9.2.1.3.1 Estimated Economic Life Versus Depreciable Life

Generally, we would expect the economic life of an asset to correspond to its depreciable life used for financial reporting. In accordance with ASC 360, depreciable life is calculated on the basis of the asset’s useful life, which is similar but not identical to the economic life an entity uses in performing the lease classification test.

The ASC master glossary defines useful life as the “period over which an asset is expected to contribute directly or indirectly to future cash flows” and economic life as “[e]ither the period over which an asset is expected to be economically usable by one or more users or the number of production or similar units expected to be obtained from an asset by one or more users.”

The objective of determining either the useful life or economic life of an asset is to identify the period over which the asset will provide benefit. The asset’s useful life represents the period over which the reporting entity will benefit from use of the asset. In contrast, the economic life represents the period over which “one or more users” will benefit from use of the asset. Therefore, the asset’s estimated depreciable life pertains to the intended use by the current owner, whereas the estimated economic life may encompass both the current and future owners of the asset.

This difference between the two definitions is not relevant in many cases since a single entity (the current owner) is often expected to use an asset for its entire life. However, depending on the facts and circumstances, it may sometimes be appropriate for an entity to use an estimated economic life for lease classification purposes that is longer than the asset’s estimated depreciable life.

Example 9-3

Company X, an automobile lessor, routinely purchases automobiles that are economically usable for seven years. Company X leases the automobiles to lessees for three years and sells the automobiles after the end of the three-year lease term. Company X may have a supportable basis for using a three-year depreciable life (with a correspondingly higher salvage value) for financial reporting purposes but a seven-year economic life for lease classification purposes.

9.2.1.3.2 Economic Life Considerations for Land

Land has an infinite economic life and therefore could never meet the criterion in ASC 842-10-25-2(c). Thus, the estimated economic-life test cannot be applied to a lease that only involves land or when land is treated as a separate lease component.

9.2.1.3.3 Impact of Lessor’s Intent to Sell Leased Property at the End of the Lease Term on Determination of the Estimated Economic Life of Leased Property

As described in ASC 842-10-25-2(c), the third criterion for classifying a lease as a sales-type lease is that the “lease term is for the major part of the remaining economic life of the underlying asset.” However, an entity should not use this criterion to classify the lease “if the commencement date falls at or near the end of the economic life of the underlying asset.”

The lessor’s intention to sell the leased property immediately after the end of the lease term should not influence the asset’s estimated economic life if the asset can still be used for its intended purpose by other users. Generally, decisions concerning economic lives for leased property will be similar to those for owned assets. Thus, the estimated economic life of a leased asset generally will be the same as the depreciable life of a similar asset for financial reporting purposes (except as discussed in Section 9.2.1.3.1).

9.2.1.3.4 Lease Agreement Covering a Group of Assets That Have Different Economic Lives

A lease contract often includes a package of equipment. For example, an equipment lease may include virtually all pieces of equipment necessary to operate a store (e.g., refrigeration cases, air conditioning units, alarm and phone systems, cash registers, and store furniture).

When pieces of equipment that have different useful economic lives are leased in the aggregate, an entity should consider the guidance in ASC 842-10-15-28, which states that a right to use an asset would be considered a separate lease component when it meets the following two criteria:

The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).
The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other.

To the extent that the above guidance does not require separation, an entity should then consider the provisions of ASC 842-10-25-5, which indicates that “[i]f a single lease component contains the right to use more than one underlying asset (see paragraphs 842-10-15-28 through 15-29), an entity shall consider the remaining economic life of the predominant asset in the lease component for purposes of applying the criterion in paragraph 842-10-25-2(c).” Regarding the assessment of the predominant asset in a lease component, paragraph BC74 of ASU 2016-02 states, in part:

The Board noted that assessing the predominant asset in a lease component that includes multiple underlying assets will be straightforward in most cases. That is, the assessment is a qualitative one that requires entities to conclude on what is the most important element of the lease, which should be relatively clear in most cases. The Board also noted that if an entity is unable to identify the predominant asset, it may indicate that there is more than one separate lease component in the contract.

Chapter 4 discusses, in detail, the guidance in ASC 842-10-15-28 on separating leasing components.

9.2.1.3.5 At or Near the End of the Remaining Economic Life

ASC 842-10

55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph] 842-10-25-2(c) . . . would be to conclude: . . .

b. A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset. . . .

If a lease component is at or near the end of its economic life, it is not subject to the economic-life test. In its 2013 leasing ED, the FASB contemplated not including this exception. Paragraph BC71 of ASU 2016-02 addresses the Board’s reasons for ultimately including the exception in the leasing guidance and states, in part:

The exception to considering this criterion when the lease commences at or near the end of the economic life of the underlying asset is contrary to the lease classification principle because a lessee can direct the use of and obtain substantially all the remaining benefits from a significantly used asset just the same as it can a new or slightly used asset. However, the Board determined that an exception is appropriate because it would be inconsistent to require that a lease covering the last few years of an underlying asset’s economic life be recorded as a finance lease by a lessee (or sales-type lease by a lessor) when a similar lease of that asset earlier in its economic life would have been classified as an operating lease. The Board concluded that this would not appropriately reflect the economics of those leases.

9.2.1.4 Substantially All of the Fair Value of the Underlying Asset — ASC 842-10-25-2(d)

ASC 842-10

25-4 A lessor shall assess the criteria in paragraphs 842-10-25-2(d) . . . using the rate implicit in the lease. For purposes of assessing the criterion in paragraph 842-10-25-2(d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount.

55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph 842-10-25-2(d)] would be to conclude: . . .

c. Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.

55-8 When evaluating the lease classification criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1), the fair value of the underlying asset should be reduced by any related investment tax credit retained by the lessor and expected to be realized by the lessor.

As indicated in ASC 842-10-25-2(d), if the “present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments . . . equals or exceeds substantially all of the fair value of the underlying asset,” the lease is classified as a sales-type lease. The present value is calculated by using a discounted cash flow approach. (See Chapter 6 for details on the amounts included in this calculation.) While a lessee will generally use its incremental borrowing rate (if the rate implicit in the lease is not readily determinable) to calculate the present value of its lease payments, as discussed in Section 7.2, a lessor must use the rate implicit in the lease. The ASC master glossary defines the rate implicit in the lease as follows:

The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.

An entity may solve for the rate implicit in the lease by using the internal-rate-of-return calculation function through either a spreadsheet database (as shown in the example below) or another calculator mechanism.

Example 9-4

A lessor leases a yacht with a fair value of $256,300 to an actor for three years for an annual payment made in arrears of $75,000. When the actor returns the yacht, the fair value of the asset is expected to be $90,000. Using an internal-rate-of-return functionality, the lessor determines that its rate implicit in the lease is 9.57 percent.

Note that, in this example, no ITCs were received and no initial direct costs were incurred.

Connecting the Dots

Calculating a Negative “Rate Implicit in the Lease”

We have observed situations in which the outcome of the calculation of the “rate implicit in the lease,” which is based on how that term is defined in ASC 842-30-20, may result in a negative discount rate. However, at the FASB’s November 30, 2016, meeting, the Board acknowledged that using a negative discount rate to determine the rate implicit in the lease (as defined in ASC 842-10-20) is inappropriate. ASU 2018-10 clarifies that lessors should use a 0 percent discount rate when measuring the net investment in a lease if the rate implicit in the lease is negative. See Section E.3.1.3 for further discussion of the ASU.

Use of Bright-Line Thresholds — Fair Value Test and “Substantially All”

The lease classification guidance in ASC 842-10-25-2 does not explicitly prescribe bright-line thresholds as part of the fair value test; therefore, an entity is permitted but is not required to assess certain quantitative bright-line thresholds when classifying a lease under ASC 842.

The implementation guidance in ASC 842-10-55-2 further states that the use of the following bright-line thresholds would be a reasonable approach to applying the lease classification criteria in ASC 842:

When determining lease classification, one reasonable approach to assessing the criteria in paragraphs 842-10-25-2(c) through (d) and 842-10-25-3(b)(1) would be to conclude:

Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.
Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.

On the basis of this implementation guidance, we would not object if an entity were to apply bright-line thresholds when classifying a lease under ASC 842. We would expect that, under such an approach, an entity would classify a lease in accordance with the quantitative result. That is, if an entity, as an accounting policy, elects a bright-line threshold of 90 percent as substantially all, when the present value of the lease payments equals 91 percent of the underlying asset’s fair value, the entity should classify the lease as a sales-type lease. The entity should not attempt to overcome the assessment with qualitative evidence to the contrary. Likewise, if, as a result of the present value calculation, the present value of the lease payments equals 89 percent of the underlying asset’s fair value, the entity should classify the lease as an operating lease (provided that other lease classification criteria are not met). We would expect that if an entity decides to apply bright-line thresholds when classifying a lease, the entity would apply those thresholds consistently to all of its leases.

Evaluating “Substantially All”

One of the most notable aspects of ASC 842 is the exclusion of “bright lines” (e.g., the 90 percent previously used in the fair value test) from the lease classification tests. However, ASC 842-10- 55-2 acknowledges that 90 percent may be an appropriate threshold for the “substantially all” criterion. See Section 9.2.1.3 for more information. An entity will need to evaluate the “substantially all” criterion when classifying a lease under ASC 842, regardless of when the lease term begins.

At or Near the End of Its Economic Life and “Substantially All”

As discussed in Section 9.2.1.3.5, the FASB allowed lessors not to consider the economic-life test if the lease commences within the final 25 percent of the total economic life of the underlying asset. Accordingly, lessors have one less criterion to assess for an asset that is near the end of its useful life; however, the “substantially all” test still applies to those same leases. Therefore, even if the underlying asset is in the last 25 percent of its economic life, sales-type lease classification may still be warranted if the lessor concludes, after considering the threshold described in ASC 842-10-55-2(c), that substantially all of the associated value is being transferred to the lessee.

Evaluating 89.9 Percent Lease Payments

Under ASC 840, there were many opportunities to create highly structured leases. Specifically, many leases were designed so that the present value of lease payments would be 89.9 percent of the fair value. Because the FASB has taken a more principles-based approach to classification in ASC 842, we do not believe that an 89.9 percent present value would necessarily result in a non-sales-type lease. However, this would depend on the entity’s accounting policies (see Section 9.2.1.3), which should be consistently applied.

Consideration of Nonperformance-Related Default Provisions

Some lease agreements contain nonperformance-related default provisions that may require the lessee to purchase the leased asset or make another payment if the lessee is in default under such provisions. For more information about this issue and about lessees’ treatment of payments associated with nonperformance-related default provisions under ASC 842, see Section 8.3.3.6. In line with the discussion in that section, lessors should generally treat these payments as variable and should consider the guidance in ASC 842-30. See Section 9.3 for more information about a lessor’s treatment of variable lease payments.

9.2.1.4.1 Lessor’s Consideration of Initial Direct Costs Related to the Rate Implicit in the Lease

In considering initial direct costs when calculating the rate implicit in the lease, a lessor must first assess the appropriate classification of the lease. This assessment would start with a determination of whether the lease (1) should be classified as a sales-type lease because it meets any of the criteria in ASC 842-10-25-2 and (2) meets the criterion in ASC 842-10-25-3A. If none of the criteria in ASC 842-10-25-2 or ASC 842-10-25-3A are met, the lessor is next required to determine whether the lease must be classified as a direct financing lease in accordance with ASC 842-10-25-3(b); if not, the lease would be classified as an operating lease.

ASC 842-10-25-2(d), which contains one of the criteria for sales-type lease classification, states:

The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.

To determine the “present value of the sum of the lease payments and any residual value guaranteed by the lessee,” the lessor must determine the “rate implicit in the lease.” The ASC master glossary defines the rate implicit in the lease as follows:

ASC 842-10-25-4 clarifies that “[f]or purposes of assessing the criterion in paragraph 842-10-25-2(d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount.”

As a result, when determining whether a lease is a sales-type lease under ASC 842-10-25-2(d) (quoted above), the lessor does not include initial direct costs in its determination of the rate implicit in the lease if the underlying asset’s fair value differs from its carrying value.

In all other cases (i.e., when the underlying asset’s fair value equals its carrying value in the determination of whether a lease is a sales-type lease under ASC 842-10-25-2(d) or whether a lease is a direct financing lease under ASC 842-10-25-3(b)), the lessor would include initial direct costs in its determination of the rate implicit in the lease.

With respect to initial recognition and measurement, a lessor is required to recognize (at commencement) a net investment in the lease for sales-type and direct financing leases. The net investment in the lease comprises the sum of the lease receivable and any unguaranteed residual value, both of which are measured at present value by using the same rate implicit in the lease that was used for lease classification purposes.

For sales-type leases, ASC 842-30-25-1(c) requires that initial direct costs be expensed “if, at the commencement date, the fair value of the underlying asset is different from its carrying amount.” In these cases, because the rate implicit in the lease (as determined during lease classification) did not include initial direct costs because they were not eligible for deferral, those costs are automatically excluded from the net investment in the lease (i.e., there is no need to remove them separately).

In all other cases (i.e., when the underlying asset’s fair value equals its carrying value in the determination of whether a lease is a sales-type lease or whether a lease is a direct financing lease under ASC 842-10-25-3(b)), “[i]f the fair value of the underlying asset equals its carrying amount, initial direct costs . . . are deferred at the commencement date and included in the measurement of the net investment in the lease” in accordance with ASC 842-30-25-1(c). Therefore, because the initial direct costs are eligible for deferral and were included in the determination of the rate implicit in the lease for classification purposes, they are automatically included in the rate used to calculate the net investment in the lease.2

This is consistent with ASC 842-30-25-1(c) (sales-type lease recognition) and ASC 842-30-25-8 (direct financing lease recognition), each of which suggests that the rate implicit in the lease is defined in such a way that initial direct costs eligible for deferral “are included automatically in the net investment in the lease; there is no need to add them separately.”

9.2.1.4.2 Unit of Account for Assessing Lease Classification

The lessor must classify a lease as a sales-type lease if (1) any of the lease classification criteria in ASC 842-10-25-2 are met and (2) there is no selling loss in a lease containing variable payments that do not depend on an index or a rate in accordance with ASC 842-10-25-3A.

In evaluating the criterion in ASC 842-10-25-2(d) (i.e., in assessing whether the lease is a sales-type lease), a multiunit real estate lessor would use the fair value of the unit allocable to the lease component in its present value test. In other words, the lessor would identify the underlying asset at the level associated with the space being leased and not beyond the identified lease component (e.g., at the level of a retail store in a shopping mall, not at the level of the shopping mall itself).

Example 9-5

Lessor A leases a retail store at the mall it owns. The fair value of the mall is $10 million, and the fair value of the individual retail store is $500,000. The present value of the lease payments for the retail store is $450,000 (there is no residual value guarantee). To determine the classification of the lease, the lessor should compare the fair value of the portion of the building allocable to the lease component ($500,000) with the present value of the lease payments ($450,000).

Connecting the Dots

ASU 2019-01 on Acquisition Costs for Lessors That Are Not Manufacturers or Dealers

In March 2019, the FASB issued ASU 2019-01, which provides guidance on how lessors that are not manufacturers or dealers (qualifying lessors) should determine the fair value of the underlying asset and apply it to lease classification and measurement. Specifically, for qualifying lessors, the fair value of the underlying asset at lease commencement should be its cost, including any acquisition costs, such as sales taxes or delivery charges. Accordingly, many costs related to the fulfillment of sales-type leases and direct financing leases should be capitalized as part of the net investment in the lease for qualifying lessors. However, if a significant lapse of time occurs between the acquisition of the underlying asset and lease commencement, lessors are required to determine fair value in accordance with ASC 820, which does not include such costs. Moreover, since this ASU does not apply to manufacturers and dealers, such lessors are always required to determine fair value in accordance with ASC 820. See Section E.3.1.7 for more information about ASU 2019-01.

9.2.1.4.3 Impracticable to Determine Fair Value

ASC 842-10

55-3 In some cases, it may not be practicable for an entity to determine the fair value of an underlying asset. In the context of this Topic, practicable means that a reasonable estimate of fair value can be made without undue cost or effort. It is a dynamic concept; what is practicable for one entity may not be practicable for another, what is practicable in one period may not be practicable in another, and what is practicable for one underlying asset (or class of underlying asset) may not be practicable for another. In those cases in which it is not practicable for an entity to determine the fair value of an underlying asset, lease classification should be determined without consideration of the criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1).

We believe it would be unlikely that a lessor would not be able to determine the fair value of an underlying asset, including portions of larger assets. Lessors that consider this paragraph to be applicable to their facts and circumstances should consult their accounting advisers.

In determining whether to classify a lease as a sales-type or direct financing lease, a lessor must determine whether “the present value of the sum of the lease payments . . . equals or exceeds substantially all of the fair value of the underlying asset” in accordance with ASC 842-10-25-2(d) (see Section 9.2.1.4). Accordingly, when classifying the lease (i.e., as a sales-type, direct financing, or operating lease), the lessor must determine the fair value of the underlying asset — for use in the fair value test — at the level associated with the identified lease component (see Section 9.2.1.4.2). This level could be a portion of a larger asset, such as a floor of an office building. If it is impracticable for a lessor to determine the fair value of an underlying asset in accordance with ASC 842-10-55-3, the lessor should assess the lease classification without considering the criterion in ASC 842-10-25-2(d) and ASC 842-10-25-3(b)(1). In this context, “practicable” means that fair value can be reasonably estimated without undue cost or effort.

Consider an example in which a lessor leases space on a cell tower (e.g., a hanger) to a lessee. The lessor previously recorded the entire cell tower (i.e., the larger asset) on its books, and the hanger is considered a portion of the larger asset. The lessor has a practice of leasing individual hangers within the cell tower to lessees; thus, the individual hanger would be the unit of account from a leasing perspective. A similar situation may arise when a lessor leases a floor of a building to a lessee. The entire building (i.e., the larger asset) is recorded on the lessor’s books. The lessor commonly leases individual floors in the building to lessees. As stated above, when classifying the lease, the lessor must determine the fair value of the underlying asset for use in the fair value test — which would be at the level of the individual hanger or individual floor in these examples — unless it is impracticable to do so.

While ASC 842 does not address how a lessor should determine the fair value of a portion of a larger asset, we believe that the lessor can use various methods to determine the fair value of a portion of a larger asset, depending on the facts and circumstances. Because a lessor will typically be able to determine the fair value of the entire larger asset (e.g., a cell tower or building, as described in the examples above), it will often be appropriate to use an “allocation approach” to allocate the fair value of the larger asset to the respective portions of the larger asset that are being leased.

For example, the fair value of the larger asset could be proportionately allocated — on the basis of the perceived value of the individual leasable spaces — to the individual portions of the larger asset that the lessor leases. When this method is used, other conditions that may be more representative of the fair value of the leased asset should be considered. In a building, for instance, higher floors are often more desirable, have a higher stand-alone selling price, and are leased at a higher cost to the lessee than lower floors. In such circumstances, use of an appropriate allocation method would result in the allocation of a greater fair value to the higher floors. Such an allocation would better represent the economics of the individual lease arrangements and better reflect the fair value of each respective portion.

Likewise, we believe that an entity that is estimating the fair value of a portion of a larger asset should consider the intended use of the asset. It is also important not to confuse relative fair value with relative construction or replacement costs. In the cell tower example described above, while the percentage of the costs for the individual hangers may not be disproportionately high compared with the cost of the overall structure, it is likely that the hangers in the aggregate account for most of the fair value of the tower since they represent its revenue-producing parts. In other words, we would sometimes expect the fair value of discrete portions of a larger asset to be disproportionate compared with that of the entire asset on a space or square-footage basis when the relative revenue-producing potential of the discrete portions is taken into account.

We generally believe that it would be unusual for a lessor not to be able to determine the fair value of a portion of an underlying asset. Further, we would expect that a lessor that can estimate the fair value of the larger asset (which will generally be the case) would typically be able to reasonably allocate an appropriate percentage of that fair value to the portion being leased without undo cost or effort.

9.2.1.4.4 Residual Value Guarantees Provided for a Portfolio of Assets

ASC 842-10

55-9 Lessors may obtain residual value guarantees for a portfolio of underlying assets for which settlement is not solely based on the residual value of the individual underlying assets. In such cases, the lessor is economically assured of receiving a minimum residual value for a portfolio of assets that are subject to separate leases but not for each individual asset. Accordingly, when an asset has a residual value in excess of the “guaranteed” amount, that excess is offset against shortfalls in residual value that exist in other assets in the portfolio.

55-10 Residual value guarantees of a portfolio of underlying assets preclude a lessor from determining the amount of the guaranteed residual value of any individual underlying asset within the portfolio. Consequently, no such amounts should be considered when evaluating the lease classification criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1).

Although a lessor would consider residual value guarantees on individual leases as part of the lease payments when performing the lease classification test, such guarantees would generally be excluded from the test when they are provided for a portfolio of assets under ASC 842-10-55-10. However, as discussed below, there is a potential exception to this rule.

Lessors often enter into lease agreements to lease multiple similar assets to lessees. In these circumstances, lessees will often guarantee the residual value for the group of assets being leased (e.g., the portfolio of underlying assets) rather than that for each individual underlying asset. ASC 842-10-55-10 states that a lessor should not consider residual value guarantees of a portfolio of underlying assets when evaluating the lease classification criteria, since “[r]esidual value guarantees of a portfolio of underlying assets preclude a lessor from determining the amount of the guaranteed residual value of any individual underlying asset within the portfolio.”

The guidance in ASC 842 on how lessors should treat residual value guarantees of a portfolio of underlying assets when classifying a lease is similar to historical practice under ASC 840. Specifically, in an inquiry, the SEC was asked to give its views on how a lessor should apply ASC 840-10-25-1(d) and ASC 840-10-25-5 in determining the minimum lease payments for lease classification purposes when the lessee provided a guarantee of the aggregate residual value of a portfolio of leased assets. ASC 840-30-S99-1 states that, in response to this inquiry, the SEC staff indicated the following:

The SEC staff believes that residual value guarantees of a portfolio of leased assets preclude a lessor from determining the amount of the guaranteed residual value of any individual leased asset within the portfolio at lease inception and, accordingly, no such amounts should be included in minimum lease payments.

Therefore, the general practice under ASC 840 was for a lessor not to include residual value guarantees for a portfolio of leased assets in the determination of minimum lease payments, since it is not possible to identify the individual residual value guarantee for any individual leased asset within the portfolio. Because the classification analysis under ASC 840 was performed on an individual-asset basis, it is rare for a lessor to include a residual value guarantee of a portfolio of assets in the determination of minimum lease payments. However, in certain circumstances, it is appropriate to do so. Specifically, under ASC 840, if a group of leased assets associated with the PRVG met the following criteria, the PRVG was factored into the calculation of minimum lease payments:

The leases commenced and ended at the same time.
The leased assets were physically similar to each other.
The variability associated with the expected residual values was expected to be highly correlated (i.e., one asset’s residual value was expected to be similar to that of the other assets’ residual values).

Under ASC 842, a lessor can account for a group of leases at a portfolio level provided that (1) the leases are similar in nature (e.g., have similar underlying assets) and (2) have identical or nearly identical contract provisions (see Section 8.2.2). In addition, paragraph BC120 of ASU 2016-02 states, in part:

[T]he Board decided to explicitly state that lessees and lessors are permitted to apply the leases guidance at a portfolio level. The Board acknowledged that an entity would need to apply judgment in selecting the size and composition of the portfolio in such a way that the entity reasonably expects that the application of the leases model to the portfolio would not differ materially from the application of the leases model to the individual leases in that portfolio.

Because ASC 842 can be applied at a portfolio level, lessors have questioned whether it is appropriate for them to factor in a residual value guarantee for a group of assets being leased when determining the lease classification of each separate lease. We believe that, when certain facts and circumstances exist, it may be appropriate for a lessor to consider a PRVG for a group of assets being leased. Consider the example below.

Example 9-6

A lessor enters into an agreement to lease 10 physically similar laptops to a lessee. The leases commence and end on the same day. The agreement has no stated renewal or purchase options. The individual assets have a fair value at commencement of $500 each and an expected residual value at the end of the lease term of $150 each. The variability associated with the expected residual value of each laptop is expected to be highly correlated. The lessee guarantees that the combined residual value of the leased assets will be $1,500. If the PRVG were excluded from the lease classification test, all of the individual leases would be operating leases. However, if the PRVG were included, classification may change depending on the attribution of the PRVG to the individual leases in the portfolio.

We believe that, as described in the example above, there are circumstances in which it may be acceptable for a lessor to include a PRVG in the classification of leased assets that are subject to a residual value guarantee for the group of assets. In such circumstances, we would expect the PRVG to be apportioned equally to each leased asset (e.g., $150 per laptop in the above example).

In addition, we believe that the lessor may consider a PRVG when classifying the individual leases within a portfolio when an arrangement meets the following criteria that were applied in practice under ASC 840 (outlined above and repurposed below):

The leases commence and end at the same time.
The leased assets are physically similar to each other.
The variability associated with the expected residual values is expected to be highly correlated.

While ASC 842-10-55-10, read literally, suggests that a PRVG should never be considered in the lessor’s determination of lease classification, we believe that the FASB did not intend to change this historical practice under ASC 840. Further, we believe that use of the criteria above will result in a lease classification that is consistent with the underlying economics of the leasing arrangement.

9.2.1.5 Underlying Asset Is Specialized and Has No Alternative Use to the Lessor at the End of the Lease Term — ASC 842-10-25-2(e)

ASC 842-10

55-7 In assessing whether an underlying asset has an alternative use to the lessor at the end of the lease term in accordance with paragraph 842-10-25-2(e), an entity should consider the effects of contractual restrictions and practical limitations on the lessor’s ability to readily direct that asset for another use (for example, selling it or leasing it to an entity other than the lessee). A contractual restriction on a lessor’s ability to direct an underlying asset for another use must be substantive for the asset not to have an alternative use to the lessor. A contractual restriction is substantive if it is enforceable. A practical limitation on a lessor’s ability to direct an underlying asset for another use exists if the lessor would incur significant economic losses to direct the underlying asset for another use. A significant economic loss could arise because the lessor either would incur significant costs to rework the asset or would only be able to sell or re-lease the asset at a significant loss. For example, a lessor may be practically limited from redirecting assets that either have design specifications that are unique to the lessee or that are located in remote areas. The possibility of the contract with the customer being terminated is not a relevant consideration in assessing whether the lessor would be able to readily direct the underlying asset for another use.

The criterion in ASC 842-10-25-2(e) states that if the “underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term,” the lease is a sales-type lease. When an underlying asset has no alternative use to the lessor at the end of a lease term, it is presumed that the lessee will consume all (or substantially all) of the benefits of the asset. The substantive lack of alternative use can be identified if there is a contractual restriction or an anticipated significant economic loss related to directing the asset for another use.

Connecting the Dots

Meeting the Criterion in ASC 842-10-25-2(e)

It is unlikely that the criterion in ASC 842-10-25-2(e) would be met in isolation because a lessor economically would not enter into an arrangement in which it would not be compensated to obtain a worthless asset at the end of a lease term. We do not believe that this criterion should be interpreted as applying to situations in which the underlying asset is near the end of its economic life and the lessee, by virtue of the lease, therefore has obtained all of the use of the asset so that it has “no alternative use.” This criterion is intended to identify situations in which the lessee uses all of the asset’s economic benefits because the asset is so specialized for that particular lessee that the lessor would not be expected to generate economic benefit from the asset’s use outside of the lease. For example, if a lease is structured with entirely variable lease payments that do not depend on an index or a rate (and the lease therefore does not meet the criterion in ASC 842-10-25-2(d)), the lease may be more likely to meet criterion (e) in isolation. However, if such leases result in a selling loss, they may need to be classified as operating leases in accordance with the amendments made by ASU 2021-05, as discussed in the section below.

9.2.1.5.1 Significant Economic Losses to Direct an Underlying Asset for Another Use

ASC 842-10-55-7 states, in part:

A practical limitation on a lessor’s ability to direct an underlying asset for another use exists if the lessor would incur significant economic losses to direct the underlying asset for another use. A significant economic loss could arise because the lessor either would incur significant costs to rework the asset or would only be able to sell or re-lease the asset at a significant [economic] loss.

Although ASC 842 does not define the term “significant economic loss,” the standard and the Background Information and Basis for Conclusions of ASU 2016-02 discuss the term “significant economic incentive.” When an entity has a significant economic incentive, it may conclude that the exercise of a purchase option or renewal option is reasonably certain in accordance with ASC 842-10-30-1 through 30-3. Because “reasonably certain” is a high threshold in the assessment of renewal (termination) options and purchase options (as discussed in Section 5.2.2), we would expect the threshold for a significant economic loss to also be high.

In addition, an entity can consider ASC 606-10-55-10 when assessing situations in which a significant loss exists. ASC 606-10-55-10 states:

A practical limitation on an entity’s ability to direct an asset for another use exists if an entity would incur significant economic losses to direct the asset for another use. A significant economic loss could arise because the entity either would incur significant costs to rework the asset or would only be able to sell the asset at a significant loss. For example, an entity may be practically limited from redirecting assets that either have design specifications that are unique to a customer or are located in remote areas. [Emphasis added]

Example 9-7

An entity leases a highly specialized underwater vehicle with patented technology to another entity. The asset took three years to produce. The lessee uses the asset to search the deep ocean floor for buried treasure in a remote area of the Arctic Ocean. The cost of transporting the asset to the search site was approximately half the cost of the asset itself, and it is not expected that any other entity is going to want to use that asset in that specific location. The lessor would incur significant losses in transporting the asset to its manufacturing facility in Chicago at the end of the lease term for refurbishment and redeployment. The lessor does not believe that any other entities would be interested in a similar use (searching the Arctic Ocean for buried treasure), and the asset is designed for that particular environment and no other. As a result, the lessor in this example would meet the criterion for classifying the lease as a sales-type lease (i.e., the criterion in ASC 842-10-25-2(e)). We believe that it is likely that other criteria for sales-type classification (e.g., the “substantially all of the fair value” test) would also be met in such situations.

9.2.1.6 Lessor’s Accounting for Certain Leases With Variable Lease Payments

In July 2021, the FASB issued ASU 2021-05, which requires a lessor to classify a lease with variable lease payments that do not depend on an index or rate as an operating lease on the lease commencement date if specified criteria are met. ASC 842-10-25-3A requires a lessor to classify a lease with variable lease payments that do not depend on an index or rate as an operating lease at lease commencement if both of the following conditions are met:

The lease would have been classified as a sales-type lease or direct financing lease in accordance with the classification criteria in ASC 842-10-25-2 and 25-3, respectively.
The lessor would have recognized a selling loss at lease commencement.

Because these leases will be classified as operating leases, when applying the guidance in ASC 842-10-25-3A, the lessor would not derecognize the underlying asset upon lease commencement but would continue to depreciate the underlying asset over its useful life. Further, in accordance with ASC 842-30-25-11(a), the lessor would recognize fixed lease payments as “income . . . over the lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the use of the underlying asset.” Variable lease payments would be recognized as “income in profit or loss in the period in which the changes in facts and circumstances on which the variable lease payments are based occur,” as indicated in ASC 842-30-25-11(b).

Note that the guidance in ASC 842-10-25-3A does not prescribe a threshold for the amount of variable payments; the guidance must be applied when a lease contains any amount of variable payments (in addition to the requirement that the lessor would have otherwise recognized a selling loss at lease commencement).

Connecting the Dots

Treatment of Leases with Variable Payments

Under ASU 2021-05, which modified the lease classification requirements, more lessors are required to classify leases as operating leases rather than as sales-type or direct financing leases. Accordingly, additional leases qualify for the lessor practical expedient in ASC 842-10-15-42A, which allows lessors to combine lease and nonlease components into a single component if certain scope requirements are met. One of these requirements is that the underlying lease component must be classified as an operating lease. (See Section 4.3.3.2 for more information about the lessor practical expedient.) In addition, the classification as an operating lease may allow certain sale-and-leaseback transactions to qualify as successful sales. (See Section 10.3 for more information about evaluating sale-and-leaseback transactions.)

Under ASC 606, variable payments are estimated and included in the transaction price subject to a constraint. By contrast, under ASC 842, variable lease payments not linked to an index or rate are generally excluded from the determination of a lessor’s lease receivable.

Accordingly, sales-type or direct financing leases that have a significant variable lease payment component may result in an entity’s determination that there would be a loss at commencement because the measurement of the lease receivable plus the unguaranteed residual asset is less than the net carrying value of the underlying asset. This could occur, for example, if lease payments are based entirely on the number of units produced by the leased asset (i.e., payments are 100 percent variable) or when a portion of the expected cash flows from the lease is variable (e.g., 50 percent of the total expected cash flows are variable). However, these transactions typically do not represent an economic loss for the lessor. A lease that meets these criteria records the lease as an operating lease rather than a sales-type or direct financing lease.

Types of Arrangements With Significant Variable Lease Payments

Lease arrangements in a number of industries often include significant or wholly variable lease payments. It is not uncommon for such arrangements to be long-term enough that they result in sales-type or direct financing lease classification under ASC 842-10-25-2 and 25-3. However, these arrangements often would be classified as operating leases since the criteria in ASC 842-10-25-3A would be met.

Arrangements in the energy sector are frequently accounted for as leases with wholly variable payment streams. For example, PPAs related to renewable energy (i.e., from solar or wind generation facilities) (1) are commonly long-term and for the major part of the economic life of the generation facility, (2) provide for payments at a fixed price per unit of electricity output (e.g., $50 per megawatt hour [MWh]), and (3) require the lessee to take all of the output produced by the facility but do not specify a minimum level of production (i.e., the volume of output is wholly variable). Although the output quantity is weather-dependent, the lessor expects the arrangement to be profitable on the basis of historical weather data.

We are also aware of arrangements in the oil and gas industry in which a company builds a gathering and processing system and leases it to a single user under a variable payment structure. For example, an exploration company with rights to multiple oil wells on dedicated acreage may contract with a midstream company to construct and lease the infrastructure necessary to gather and process the oil extracted from the wells. The arrangement may be long-term and for a major part of the economic life of the infrastructure, and the payment for the use of the infrastructure may be 100 percent variable (e.g., a fixed price per unit multiplied by the number of units gathered or processed) without a minimum volume requirement. The midstream company would be willing to accept variable consideration in the arrangement if reserve data related to the wells suggest that a sufficient volume of oil will be extracted over the term of the contract to make the arrangement profitable.

In the real estate sector, a commercial real estate lease arrangement (e.g., a lease of retail space) may be priced in such a way that a significant amount of the expected payments is contingent on the lessee’s sales (e.g., payments that are a fixed percentage of the retail store’s sales for a month) and the lease could be for a significantly long enough period to trigger the economic-life classification test. Arrangements of this type allow the property owner to participate in the upside of the retail store’s business and are expected to be profitable.

Finally, in the health care industry, it is not uncommon for a hospital to contract with a medical device owner for the use of specific medical equipment for a major part of the economic life of the equipment. This type of arrangement is often priced in such a way that the consideration is based entirely on the hospital’s ongoing purchase of “consumables,” which allow the equipment to function as designed and may have no minimum volume requirement. The medical device owner is willing to accept variable consideration in the arrangement because demand for the associated health care services suggests that a sufficient volume of consumables will be purchased by the hospital over the term of the contract to make the arrangement profitable.

9.2.2 Direct Financing Lease

If a lease does not meet any of the criteria for classification as a sales-type lease, the lessor must assess whether it has relinquished control of the underlying asset but has not transferred control to the lessee. The lessor would classify a lease that does not meet any of the criteria for a sales-type lease as a direct financing lease if two criteria are met, as described below, and the criteria in ASC 842-10-25-3A are not met.

Direct financing leases are typically considered a financial product and historically did not result in a “selling profit or loss” since the lessor typically acquired the asset contemporaneously with the leasing transaction and, accordingly, the carrying value of the underlying asset equaled its fair value on lease commencement. However, under ASC 842, this is not a condition of a direct financing lease so a selling profit or loss could result, as with a sales-type lease. However, with a direct financing lease, the selling profit would be recognized over the lease term as an adjustment to the yield, while the selling profit or selling loss would be recognized immediately for a sales-type lease. Another key difference between a direct financing lease and a sales-type lease is that a lessor would include residual value guarantees from third parties in its fair value classification test for a direct financing lease. In fact, this third-party residual value guarantee would be the only reason a lessor could classify a lease as a direct financing lease.

Bridging the GAAP

Different Treatment of Selling Profit in Direct Financing Leases

Under ASC 842, a lessor in a direct financing lease must defer selling profit at lease commencement and recognize it over the lease term. In contrast, IFRS 16 requires a lessor to recognize profit or loss in a finance lease at lease commencement. While the two standards may significantly differ in this respect, this issue may not arise frequently given the scarcity of leases with third-party residual value guarantees that result in a selling profit.

9.2.2.1 Criteria

ASC 842-10

25-3 When none of the criteria in paragraph 842-10-25-2 are met: . . .

b. A lessor shall classify the lease as either a direct financing lease or an operating lease. A lessor shall classify the lease as an operating lease unless both of the following criteria are met, in which case the lessor shall classify the lease as a direct financing lease:

1. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.

2. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

9.2.2.1.1 First Criterion — Present Value of Lease Payments and Any Residual Value Guarantee Equals or Exceeds Substantially All of the Fair Value of the Underlying Asset

The present value of lease payments includes any payments described in ASC 842-10-30-5 (see Chapter 6). However, when determining whether a lease is a sales-type or direct financing lease, a lessor includes different amounts in the lease payments with respect to residual value guarantees. In performing the sales-type lease classification test, lessors only include the residual value guarantee provided by the lessee. The direct financing lease classification test takes it one step further and requires a lessor to include any residual value guaranteed by any third party unrelated to the lessor. When performing the direct financing lease test, an entity would apply the “substantially all” criterion in the same manner as it would when performing the sales-type classification test addressed in ASC 842-10-25-2(d) (e.g., 90 percent of the fair value). See Section 9.2.1.4 for more information.

Residual value guarantees provided for a portfolio of leased assets and not for individual leased assets should not be included in the lessor classification assessment, as described in Section 9.2.1.4.4.

A lease that does not meet the “substantially all” criterion in ASC 842-10-25-3(b)(1) is an operating lease.

When performing the direct financing lease classification test as described above an entity may solve for the rate implicit in the lease for a direct financing lease by using the internal-rate-of-return calculation function through either a spreadsheet database or another calculator mechanism, as described in Section 9.2.1.4.

Example 9-8

A lessor leases a luxury tour bus with a fair value of $7,230,589 (which equals the bus’s carrying value) to a music group for three years for an annual payment made in arrears of $2,000,000. The lessor incurs $25,000 in initial direct costs. When the music group returns the tour bus, the fair value of the asset is expected to be $4,023,023. Using an internal-rate-of-return functionality, the lessor determines that its rate implicit in the lease is 14.68 percent.

Note that, in this example, no ITCs were received. Also, because the fair value of the bus equals its carrying value, the initial direct costs were included in the calculation of the rate implicit in the lease. See Section 9.2.1.4.1 for more information about how to consider initial direct costs in the determination of the lease’s implicit rate.

9.2.2.1.1.1 Impact of a Lessor’s Subsequent Purchase of Residual Value Insurance on Lease Classification

Under ASC 842-10-25-3(b)(1), when a lessor calculates lease payments to assess whether the lease should be classified as a direct financing lease or operating lease, the lessor must classify a lease as a direct financing lease if the “present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments . . . and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.” Accordingly, if a lessor purchases residual value insurance at the commencement of the lease, the amount of the residual covered by the insurance would be included in the lessor’s computation as part of the direct-financing lease classification test. In some circumstances, a lessor may purchase residual value insurance for property leased under an operating lease after the commencement of that lease in an amount that would have required classification of the lease as a direct financing lease if that insurance had been purchased at the commencement of the lease.

A lessor’s purchase of residual value insurance from a third party (unrelated to the lessor or the lessee) after the commencement of the lease would not constitute a lease modification and trigger a reevaluation of the lease’s classification in accordance with ASC 842-10-25-8.

A lessor’s acquisition of residual value insurance after the lease commencement date, in the absence of a change in the lease’s provisions that the lessor and lessee mutually agree to, does not represent a change in the lease provisions as contemplated by the definition of a “lease modification” in ASC 842-10-20. Accordingly, the lessor’s purchase of this insurance does not create a modified lease (that is not a separate contract) that must be reclassified in accordance with ASC 842-10-25-1 and ASC 842-10-25-8 through 25-10 (see Section 9.3.4 for more information).

Note that if residual value insurance from a third party was contemplated or entered into at or near the same time of lease commencement, the lessor should consider whether to include this information in its lease classification assessment.

9.2.2.1.2 Second Criterion — It Is Probable That the Lessor Will Collect the Lease Payments

The second criterion for direct-financing lease classification in ASC 842-10-25-3(b) indicates that it must be “probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.” In this context, collectibility is only assessed at lease commencement; changes in collectibility will not result in a change in classification.

If the lease does not meet this criterion, the lease is an operating lease.

Connecting the Dots

Collectibility Issues Related to Concepts in ASC 606

For a contract to be within the scope of ASC 606, collectibility must be probable (step 1). Similarly, under ASC 842, no lease-related recognition or measurement occurs when collectibility is not probable. Therefore, ASC 606 and ASC 842 are aligned with respect to the deposit liability concept.

When the sales-type lease consideration does not meet the probability threshold, the sale is only recognized when either (1) the contract has been terminated and the lease payments received from the lessee are nonrefundable or (2) the lessor has repossessed the underlying asset, the lessor has no further obligation to the lessee under the contract, and the lease payments received from the lessee are nonrefundable.

The underlying principles in ASC 606 are similar. Specifically, ASC 606-10-25-7 states:

When a contract with a customer does not meet the criteria in paragraph 606-10-25-1 and an entity receives consideration from the customer, the entity shall recognize the consideration received as revenue only when one or more of the following events have occurred:

The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.
The contract has been terminated, and the consideration received from the customer is nonrefundable.
The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable.

The ongoing evaluation of (or lack thereof) whether the lease payments and any residual value guarantees become probable over the lease term is similar to the ongoing assessment required by ASC 606. However, an important distinction is that a lessor would never reassess the probability threshold once it is met, since the single obligation to deliver the leased asset has already been fulfilled (i.e., there is no future performance, which may occur in a revenue contract as future goods and services are delivered).

9.2.3 Operating Lease

If the lease does not meet any of the five criteria for a sales-type lease or the two criteria for a direct financing lease, the lease is an operating lease.

In addition, certain leases with variable lease payments that do not depend on an index or rate that would have been classified as sales-type or direct financing leases, and for which the lessor would have recognized a selling loss, will also be classified as operating leases. See Section 9.2.1.6 for more information.

Connecting the Dots

Operating Lease Classification

Lessors are required to first evaluate whether a lease is a sales-type lease; if the lease is not a sales-type lease, the lessor must assess whether it is a direct financing lease. A lessor can only conclude that a lease is an operating lease if it does not meet the criteria for either of the other two classifications. With the exception of the provisions of ASU 2021-05, there are no separate criteria for classifying an operating lease.

Footnotes

If a lease component is at or near the end of its economic life, it is not subject to the economic life test. See Section 9.2.1.3.1 for more information.

For example, the inclusion of initial direct costs in the determination of the rate implicit in the lease results in a lower rate (see Cases A and C in Example 1, which begins in ASC 842-30-55-19). This lower implicit rate applied to the future lease payments effectively results in a higher net investment in the lease, which inherently includes the initial direct costs.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.