9.3 Recognition and Measurement

The next subsections provide guidance on how a lessor should account for each type of lease in each phase of the lease “life cycle.”

Not all leases will reach all points in the life cycle (e.g., not every lease will be modified), but the recognition and measurement requirements related to each phase are unique. How the lessor reflects these events in its financial statements largely depends on the type of lease.

9.3.1 Lease Inception

Lease inception is the date on which the terms of the contract are agreed to and the agreement creates enforceable rights and obligations. In accordance with ASC 842-10-15-2, at contract inception, an entity identifies whether a contract is or contains a lease, as well as the components in the contract (e.g., a service component) and allocates consideration on the basis of stand-alone selling prices. See Chapter 3 for more information on how to identify a lease and Chapter 4 for a discussion on identifying components in a contract.

9.3.2 Lease Commencement (Initial Measurement and Recognition)

The table below summarizes the recognition implications associated with lease commencement and initial measurement for each of the three lease classification types and includes cross-references to the sections of this Roadmap that contain additional details.

Lease Classification	Balance Sheet Recognition	Income Statement Recognition
Sales-type lease — collectibility is probable (see Section 9.3.7.1)	Recognize a net investment in the lease. The net investment in the lease comprises the sum of the lease receivable and the present value of the unguaranteed residual value. Derecognize the carrying value of the underlying asset. If the fair value of the underlying asset equals the carrying value, defer any initial direct costs.	Recognize any selling profit or selling loss immediately. If the fair value of the underlying asset does not equal the carrying value, expense any initial direct costs immediately.
Sales-type lease — collectibility is not probable (see Section 9.3.7.2)	None, unless the payments are made up front. If the payments are up front, recognize consideration received as a deposit liability.	Recognize any selling loss immediately. If the fair value of the underlying asset does not equal the carrying value, expense any initial direct costs immediately.
Direct financing lease (see Section 9.3.8.1)	Recognize a net investment in the lease. The net investment in the lease comprises the sum of the lease receivable and the present value of the unguaranteed residual value. Defer the initial direct costs and selling profit within the net investment in the lease. Derecognize the carrying value of the underlying asset.	Recognize any selling loss immediately. Do not recognize any selling profit at commencement.
Operating lease (see Section 9.3.9.1)	Defer initial direct costs. If lease payments are received up front, recognize consideration received as a deferred rent liability.	None.

Connecting the Dots

Treatment of Initial Direct Costs Under ASC 842 Is Similar to Treatment of Contract Costs Under ASC 606

The recognition of initial direct costs in connection with a sales-type lease is analogous to that related to a product sale under ASC 606. When an entity sells a product in accordance with ASC 606, any costs of obtaining a contract (i.e., initial direct costs) are recognized in connection with that product sale. Similarly, when a sales-type lease is recognized, initial direct costs are expensed immediately when the fair value of the asset differs from its carrying amount.

When initial direct costs associated with an operating lease are recognized, they are deferred and expensed over the lease term, similarly to how such costs (e.g., sales commissions paid) would be recognized in an arrangement in which services are being delivered over time. In both the operating lease and services arrangement, such costs are recognized over time to align with the delivery of the service.

9.3.2.1 Lessor’s Accounting for Lease “Fulfillment” Costs

In addition to the costs of negotiating and arranging the lease, lessors often incur certain costs related to fulfillment of the lease (e.g., costs of mobilizing the asset) after lease inception but before lease commencement. Since these costs are related to fulfilling, rather than obtaining, the lease, they would not meet the definition of initial direct costs. Because the cost accounting guidance in ASC 842 is limited to initial direct costs, questions have arisen about how a lessor should account for the costs of fulfilling the lease before the lease commences.

ASC 842 provides guidance on accounting for initial direct costs, which ASC 842-10-20 defines as “[i]ncremental costs of a lease that would not have been incurred if the lease had not been obtained.” Further, ASC 842-10-30-9 and 30-10 provide the following guidance on the types of costs that are and are not deemed to be initial direct costs:

30-9 Initial direct costs for a lessee or a lessor may include, for example, either of the following:

Commissions
Payments made to an existing tenant to incentivize that tenant to terminate its lease.

30-10 Costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as fixed employee salaries, are not initial direct costs. The following items are examples of costs that are not initial direct costs:

General overheads, including, for example, depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time
Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities
Costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms and conditions, or evaluating a prospective lessee’s financial condition.

The definition of initial direct costs in ASC 842 is largely consistent with the definition of “incremental costs of obtaining a contract with a customer” in ASC 340-40, which applies to costs related to contracts within the scope of the revenue recognition guidance in ASC 606. The FASB discussed the link between “initial direct costs” and “incremental costs of obtaining a contract with a customer” at its May 2014 meeting. Specifically, the Board rejected an alternative approach related to expanding the definition of initial direct costs and confirmed that these costs should only include the costs of negotiating and arranging the lease.

In addition to guidance on incremental costs of obtaining a contract, ASC 340-40 provides guidance on accounting for certain contract fulfillment costs incurred by a seller in a revenue arrangement. However, unlike ASC 340-40, ASC 842 does not provide lessors with any additional cost guidance beyond the guidance on initial direct costs.

On the basis of a technical inquiry with the FASB staff, we understand that a lessor should first consider whether the costs of fulfilling a lease before lease commencement are within the scope of other GAAP. If these costs are not within the scope of other GAAP, a lessor could elect, as an accounting policy, to account for the costs under either of the following approaches:

Approach A — Analogize to the guidance on contract fulfillment costs in ASC 340-40 (for more information, see Chapter 13 of Deloitte’s Roadmap Revenue Recognition) and capitalize such costs as appropriate. A lessor that elects this approach would be required to evaluate the criteria in ASC 340-40-25-5 to determine whether such costs should be capitalized. ASC 340-40-25-5 states:
An entity shall recognize an asset from the costs incurred to fulfill a contract only if those costs meet all of the following criteria:
1. The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (for example, costs relating to services to be provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved).
2. The costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future.
3. The costs are expected to be recovered.
Approach B — Expense the costs as incurred.3

On the basis of the aforementioned technical inquiry, lessors should apply the accounting policy election consistently on an entity-wide basis to all leases and should disclose the accounting policy elected, if material.

The above approaches are consistent with a speech given by Andrew Pidgeon, a professional accounting fellow in the SEC’s Office of the Chief Accountant, at the 2018 AICPA Conference on Current SEC and PCAOB Developments. Mr. Pidgeon stated, in part:

For example, a lessor may incur costs to transport a leased asset to the lessee. If the specific lessor costs are not within the scope of other GAAP, and to the extent the costs would qualify for deferral if the lease was within the scope of Topic 606, in lieu of recognizing those costs in current period earnings, the staff did not object to a lessor’s analogy to Subtopic 340-40 as an accounting policy election. [Footnote omitted]

If a lessor elects to follow Approach A, its subsequent accounting should be in line with the guidance in ASC 340-40-35-1 that requires any asset recognized from contract fulfillment costs to be “amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates.” Therefore, for operating leases, a lessor applying Approach A would typically amortize (i.e., expense) any capitalized costs over the lease term, which is aligned with a view that the lessor in an operating lease is providing the use of its asset to the lessee over the lease term (i.e., the related goods or services are being provided over time in a manner similar to a service). In contrast, for sales-type leases or direct financing leases, the related good or service is typically delivered at lease commencement with the transfer of the asset to the lessee (in a manner similar to the sale of a good that may include a significant financing component). Therefore, any eligible fulfillment costs in a sales-type or direct financing lease that meet the criteria in ASC 340-40 for capitalization would typically be amortized (i.e., expensed) fully at lease commencement.

In addition, see the Connecting the Dots in Section 9.2.1.4.2 for discussion of ASU 2019-01, under which lessors other than manufacturers or dealers should capitalize lease fulfillment costs as part of the net investment in the lease for sales-type leases and direct financing leases when certain conditions are met.

Example 9-9

A shipowner enters into a contract with a charterer (i.e., the customer) to give the charterer exclusive use of its vessel for two years in exchange for fixed consideration of $1,000 per month (i.e., total contractual consideration of $24,000). The contract is structured as a time charter in which the charterer has full discretion over the ports visited, routes taken, vessel speeds (within the limits established in the contract), and number of trips the vessel makes during the contract term. Because of contractual restrictions, the charterer is only permitted to send the vessel to safe ports and the vessel can only carry lawful cargo. The contract explicitly prevents the shipowner from substituting the vessel during the contract term unless the vessel is damaged. The shipowner has concluded that the vessel represents an identified asset and that the charterer has the right to control the use of the vessel during the contract term; therefore, the contract contains a lease of the vessel. In addition, the shipowner (lessor) has evaluated the lease and has determined that it is an operating lease.

Before the lease commences, the shipowner incurs certain lease fulfillment costs (e.g., transporting the vessel to the contractual point of origin). Because such costs are not related to negotiating and arranging a lease, they do not meet the definition of initial direct costs under ASC 842. The shipowner should first evaluate whether these costs are within the scope of any other GAAP. In the absence of directly relevant guidance, the shipowner may elect to do either of the following:

Analogize to the contract fulfillment guidance in ASC 340-40 to account for such costs. Specifically, the shipowner would evaluate the criteria in ASC 340-40-25-5 (quoted above) to determine whether the costs should be capitalized.
Expense the costs as incurred.

The shipowner should apply its election consistently to all leases and disclose the accounting policy elected, if material.

9.3.3 Subsequent Measurement

The table below summarizes recognition implications associated with subsequent measurement for each of the three classification types and includes cross-references to the sections of this Roadmap that contain additional details.

Lease Classification	Balance Sheet Recognition	Income Statement Recognition
Sales-type lease — collectibility is probable (see Section 9.3.7.1)	Reduce the net investment in the lease for consideration received from the lessee. Increase the net investment in the lease for interest income earned. Reduce the carrying value of the net investment in the lease due to any impairment.	Recognize interest income on the basis of the net investment in the lease at the implicit rate in the lease. Recognize any impairments.
Sales-type lease — collectibility is not probable (see Sections 9.3.7.2 and 9.3.7.3)	If collectibility remains not probable, recognize consideration received as a deposit liability and continue to measure the underlying asset in accordance with ASC 360. If collectibility becomes probable during the lease term, derecognize any deposit liability, derecognize the underlying asset, and recognize a net investment in the lease (taking into account the sum of the lease receivable and the unguaranteed residual value).	If collectibility remains not probable, recognize depreciation expense for the underlying asset and any impairments. If collectibility becomes probable during the lease term, recognize selling profit or loss. Over the remainder of the lease term, recognize interest income on the basis of the net investment in the lease at the implicit rate in the lease. Recognize any impairments.
Direct financing lease (see Section 9.3.8.1)	Reduce the net investment in the lease for consideration received from the lessee. Increase the net investment in the lease for interest income earned. Reduce the carrying value of the net investment in the lease due to any impairment.	Recognize interest income on the basis of the net investment in the lease at the implicit rate in the lease. Recognize any impairments.
Operating lease (see Section 9.3.9.1)	Recognize any deferred rent receivable/liability. Reduce capitalized initial direct costs for amortization. Measure the underlying asset in accordance with ASC 360.	Recognize lease income on a straight-line basis (or by using another systematic and rational basis, if appropriate). Amortize any initial direct costs. Recognize depreciation expense for the underlying asset and any impairments.

9.3.4 Lease Modification

ASC 842-10-20 defines a lease modification as follows:

A change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (for example, a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term).

Connecting the Dots

Rent Concessions Provided as a Result of COVID-19

In response to the COVID-19 pandemic, the FASB provided both lessees and lessors with relief related to accounting for rent concessions resulting from COVID-19. An entity that elects to apply the relief to qualifying concessions may choose to account for the concessions by either (1) applying the modification framework for these concessions in accordance with ASC 840 or ASC 842 as applicable or (2) accounting for the concessions as if they were made under the enforceable rights included in the original agreement and are thus outside of the modification framework. See Section 17.3.4 for more information.

On the other hand, for rent concessions that do not qualify for the COVID-19 relief, regardless of whether such concessions are offered by the lessor or negotiated by the lessee, an entity must evaluate (1) the lessee’s enforceable rights under the contract to receive such concessions (for example, force majeure or other similar clauses that apply upon the occurrence of unforeseen events or circumstances may trigger rent concessions) and (2) whether other terms and conditions of the contract have changed that result in a change in the scope of or consideration related to the lease. If, on the basis of an evaluation of the factors mentioned above, it is concluded that the lessee possesses an enforceable right to receive the rent concession under the original lease contract and no other terms and conditions have changed, the rent concession would be accounted for under the original lease contract (for example, as negative variable rent). Otherwise, the rent concession should be accounted for as a lease modification in accordance with the guidance discussed in this section.

When a lease modification occurs, an entity may or may not be required to reevaluate the lease classification.

ASC 842-10

25-1 . . . 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. . . .

25-8 An entity shall account for a modification to a contract as a separate contract (that is, separate from the original contract) when both of the following conditions are present:

The modification grants the lessee an additional right of use not included in the original lease (for example, the right to use an additional asset).
The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee.

25-9 If a lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8, the entity shall reassess the classification of the lease in accordance with paragraph 842-10-25-1 as of the effective date of the modification.

25-10 An entity shall account for initial direct costs, lease incentives, and any other payments made to or by the entity in connection with a modification to a lease in the same manner as those items would be accounted for in connection with a new lease.

25-18 See Examples 15 through 22 (paragraphs 842-10-55-159 through 55-209) for illustrations of the requirements on lease modifications.

55-159 Examples 15 through 22 illustrate the accounting for lease modifications.

Whenever there is a substantive change in the terms and conditions of a contract, the lessor should reassess whether the contract is or contains a lease. (See Section 8.6.1.1 for additional discussion.4) In addition, as noted above, when the terms and conditions of a lease contract are modified, resulting in a change in the scope of or consideration for a lease, the lessor must evaluate whether (1) “an additional right of use not included in the original lease” is being granted as a result of the modification and (2) there is an increase in the lease payments that is “commensurate with the standalone price for the additional right of use.” If the modification does not meet both of these conditions, the lessor must reassess the lease’s classification. See Section 8.3.4 for considerations related to lease classification reassessment. In a manner similar to the ASC 606 modification framework, any remaining consideration in the contract, including any termination penalty received from or paid to a lessee as part of a partial termination of a lease, should be reallocated to the remaining components in the contract and recognized prospectively. See Section 8.6.3.7.1 for additional discussion.5

If both of the conditions are met, the entity would account for a lease modification as a separate contract and would apply the guidance in ASC 842 to the separate contract. See Section 8.6.2 for additional discussion of the accounting for a modification as a separate contract.6

Example 9-10

Modification Resulting in a Separate Contract

A lessor enters into an arrangement to lease 15,000 square feet of retail space in a shopping mall for 20 years. At the beginning of year 10, the lessor agrees to amend the original lease to include an additional 5,000 square feet of space adjacent to the existing space currently being leased when the current tenant vacates the property in 18 months. The increase in lease consideration as a result of the amendment is commensurate with the market rate for the additional 5,000 square feet of space in the shopping mall. The lessor would account for this modification (i.e., the lease of the additional 5,000 square feet) as a separate contract because the modification provides the lessee with a new ROU asset at a price that reflects its stand-alone price.

Example 9-11

Modification Not Resulting in a Separate Contract

A lessor enters into an arrangement to lease 15,000 square feet in a shopping mall for 20 years. At the beginning of year 10, the lessor agrees to amend the original lease by reducing the annual rental payments from $60,000 to $50,000 for the remaining 10 years of the agreement. Because the modification results in a change only to the lease consideration (i.e., the modification does not result in an additional ROU asset), the lessor would not account for this modification as a separate contract.

Changing Lanes

In a Lease Modification, Entities Are No Longer Required to Consider Previous Terms and Conditions in Determining Lease Classification

Under ASC 840, there was a two-step process related to an entity’s determination of whether a change in lease classification was required. Specifically, an entity determined whether the substitution of the modified lease provisions would have resulted in a different lease classification at inception of the lease, as though such terms had been in place since inception. If so, the lease was considered a new agreement to be assessed for classification by using updated assumptions. The guidance in ASC 840 therefore differs from that in ASC 842, which neither requires nor permits a lessor to consider the terms and conditions or facts and circumstances present as of lease inception (or commencement). As the Board suggests in paragraph BC169 of ASU 2016-02, it is making this change to reduce the complexity of the lease modification guidance and make it “more intuitive to apply.”

Connecting the Dots

Contract Modifications Accounted for as a Separate Contract Under ASC 842 Are Similar but Not Identical to Those Under ASC 606

ASC 606-10-25-12 indicates that a contract modification must be accounted for as a separate contract if both of the following conditions are met:

“The scope of the contract increases because of the addition of promised goods or services that are distinct.”
“The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract.”

These conditions are similar to those in ASC 842 that apply to the determination of whether a lease modification should be accounted for as a separate contract. The aligned modification guidance should reduce the complexity of accounting for the modification of a contract that includes both (1) lease components and (2) nonlease components within the scope of ASC 606.

However, there is a key distinction between modifications under ASC 842 and those under ASC 606 with respect to the first condition related to accounting for a modification as a separate contract. That is, for the modification to be accounted for as a separate contract under ASC 842-10-25-8(a), it must grant “an additional right of use not included in the original lease”; on the other hand, ASC 606-10-25-12(a) requires that the modification result in “the addition of promised goods or services that are distinct.” On the surface, these two requirements appear similar, since both mandate the addition of something new to the contract. However, ASC 842 requires that this addition be a new right of use “not included in the original lease.” As a result, a modification that extends the right to use the same underlying asset subject to the existing lease does not qualify to be accounted for as a separate contract under ASC 842, even if that extension is priced at its stand-alone price. In contrast, an extension of the same service (e.g., maintenance) subject to an existing revenue arrangement could qualify to be accounted for as a separate contract under ASC 606. If a lessor has not elected the practical expedient not to separate lease and nonlease components and a modification includes an extension of both an existing right of use and an existing service, the modification would not qualify to be accounted for as a separate contract since it would include more than just the addition of promised goods or services that are distinct. This is because the modification guidance is applied at the contract level rather than at the level of the agreement’s individual components, even when different Codification topics apply to such components.

9.3.4.1 Evaluation of “Terms and Conditions” and “Facts and Circumstances”

ASC 842-10-25-9 requires a lessor to reassess a lease’s classification as of the effective date of the modification in accordance with ASC 842-10-25-1. This assessment is made on the basis of the lease’s “modified terms and conditions” as well as the “facts and circumstances” as of the effective date. “Terms and conditions” are legal stipulations in the contract; facts and circumstances are factors outside the contract. Examples of each that may affect lease classification include:

Terms and conditions:
- Purchase option on underlying asset.
- Transfer of the title of the underlying asset at the end of the lease term.
- Change in a contractual right or obligation in the contract (e.g., lease term or lease payment).
Facts and circumstances:
- Change in the fair value of the asset.
- Change in the economic life of the asset.
- No alternative use of the underlying asset for the lessor.
- Change in the entity’s view on whether there is a significant economic incentive to purchase or renew the lease.

Note that changes in facts and circumstances alone would never constitute a lease modification; an entity would only need to determine whether a lease classification reassessment must be performed when there are actual changes in the terms and conditions of the contract. However, the lease classification assessment should take into account facts and circumstances present as of the modified lease classification date.

Connecting the Dots

Significant Asset Improvements7

Although changes in facts and circumstances alone would never constitute a lease modification, questions have arisen about whether a change in rights and obligations that results in a change in the scope of or the consideration for a lease could constitute a lease modification without a written amendment to the contract. For example, a lessor may decide to make a significant improvement to an underlying asset during the lease term without making a corresponding change to the lease contract. In these circumstances, we believe that the lessor should consider whether the significant asset improvement has enhanced the scope of the lessee’s right of use and whether the lessee’s enhanced right of use is legally enforceable. If the significant asset improvement has changed the conditions of the lease by providing the lessee with a legally enforceable, enhanced right of use, we believe that it would generally be appropriate for the lessor to conclude that a lease modification has taken place.8

Likewise, we believe that a lessor should also consider whether a significant asset improvement has resulted in such a significant change in the nature of the asset that it has effectively substituted the underlying asset with a new asset. See Section 3.3.3.5 for additional information on how parties to a contract should account for the supplier’s exercise of a nonsubstantive substitution right.

The decision tree below illustrates the lessor’s evaluation of a change in terms and conditions of a contract that is, or contains, a lease component.

The diagram below illustrates the different types of potential lease modifications. The Roadmap sections cross-referenced in the diagram discuss each of the modification types in detail.

9.3.4.2 Circumstances in Which a Lessor Is Required to Update Stand-Alone Selling Prices

Lessors are required to allocate the consideration in the contract to the separate lease and nonlease components in accordance with step 4 of the revenue recognition model in ASC 606-10-32-28 through 32-41. That is, lessors will generally allocate the consideration in the contract on the basis of the relative stand-alone selling price. The stand-alone selling price, in accordance with ASC 606-10-32-32, is “the price at which an entity would sell a promised good or service separately to a customer.” See Section 4.4.2.2 for further discussion of allocating consideration in the contract.

Generally, a lessor does not remeasure its net investment in a lease (sales-type lease or direct financing lease) or its assets and liabilities associated with an operating lease. However, if a lease modification is not accounted for as a separate contract in accordance with ASC 842-10-25-8 (as discussed above), the lease balance may need to change. Specifically, ASC 842-10-35-6 states that a “lessor shall not remeasure the lease payments unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.” See Section 6.10 for more information about subsequent measurement of lease payments.

Under ASC 842-10-15-41, if a lease modification is not accounted for as a separate contract (as discussed in Section 4.4.2.3), a “lessor shall remeasure and reallocate the remaining consideration in the contract when there is a contract modification that is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.”

While the guidance explicitly specifies that a lessor should reallocate consideration in the contract when there is a contract modification that is not accounted for as a separate contract, it is not clear on whether the lessor would need to reevaluate stand-alone selling prices as of the modification date or whether it would be appropriate to retain the original inception-date relative stand-alone selling prices and thus to carry forward the original allocation percentages determined in accordance with ASC 606. However, the guidance in ASC 842 is intentionally aligned with several concepts in ASC 606, including guidance on contract modifications. Therefore, a lessor’s contract modification is similar to a revenue contract modification in accordance with ASC 606-10-25-12 and 25-13, under which an entity must account for a contract modification as if it were a termination of the existing contract, and the creation of a new contract, when certain conditions are met (as explained in the Connecting the Dots above). As a result, an entity would need to evaluate updated stand-alone selling prices for the newly created contract.

Therefore, when a lease contract is modified and is not accounted for as a separate contract, the allocation to the remaining lease and nonlease components is performed on the basis of the facts and circumstances (and the modified terms and conditions, if applicable) that exist as of the date of the modification (see Section 9.3.4.1). Given that the lessee and lessor have agreed to the modified terms and conditions as of the modification date, the economic split between the lease and nonlease components should also be revised.

We believe that it would be counterintuitive not to revise the relative stand-alone selling prices and related allocation percentages since there could be additional (or fewer) components in the contract after the modification. For example, if the lessor modifies the contract, the modification does not result in a separate contract, and the modification results in the addition (or elimination) of the right to use one or more underlying assets, it would not make sense to retain the allocation percentages that were determined at lease inception. The reason such retention would not make sense in such circumstances is that either (1) any new components in the contract would not have been included in the initial determination (when new components are added) or (2) any eliminated components would have been included in the initial determination and would no longer be subject to allocation (when there are partial terminations — see the next section).

In addition, a lessor would apply the revenue contract modification guidance to the nonlease (revenue) components that are accounted for in accordance with ASC 606. For those components, an entity would be required to evaluate the updated stand-alone selling prices at the time of modification in accordance with ASC 606-10-25-12 and 25-13. (For more information, see Sections 9.2.1 and 9.2.2 of Deloitte’s Roadmap Revenue Recognition.) Therefore, the allocation of consideration among the nonlease components would change. This guidance further supports the view that a lessor should apply the same method to the lease components. The entire arrangement, including both lease and nonlease components, would be subject to an evaluation of the updated stand-alone selling prices at the time of modification.

9.3.5 Lease Termination

The table below summarizes recognition implications associated with a lease termination for each of the three classification types and includes cross-references to the sections of this Roadmap that contain additional details.

Lease Classification	Balance Sheet Recognition	Income Statement Recognition
Sales-type lease — collectibility is probable (see Section 9.3.7.8)	Derecognize the net investment in the lease and measure the carrying value of the asset recognized on the basis of the net investment in the lease, less any impairments.	Recognize any ASC 310 or ASC 326 impairments.
Sales-type lease — collectibility is not probable (see Section 9.3.7.8)	Derecognize the deposit liability if the balance is nonrefundable to the lessee and either (1) the lease is terminated or (2) the lessor has repossessed the underlying asset and has no further obligation under the contract.	If the lessor can derecognize any deposit liability, recognize the amounts as selling profit.
Direct financing lease (see Section 9.3.8.5)	Derecognize the net investment in the lease and measure the carrying value of the asset recognized on the basis of the net investment in the lease, less any impairments.	Recognize any ASC 310 or ASC 326 impairments.
Operating lease (see Section 9.3.9.6)	Write off any deferred rent receivables (or prepaid lease liability if amounts are nonrefundable to the lessee) or initial direct costs.	Recognize any impact of the write-offs.

Note that if the lease termination occurs on a future date, for accounting purposes, the change represents a lease modification rather than a termination and the lessor will recognize remaining payments as income over the remaining lease life.

Any termination penalty received from or paid to a lessee as part of a full termination of a lease should be included in the determination of any gain or loss upon termination. However, any termination penalty received from or paid to a lessee as part of a partial9 termination of a lease should be reallocated to the remaining components in the contract and recognized prospectively. See Section 8.6.3.7.1 for additional discussion.10

9.3.6 End of Lease

The table below summarizes recognition implications associated with lease expiration for each of the three classification types and includes cross-references to the sections of this Roadmap that contain additional details.

Lease Classification	Balance Sheet Recognition	Income Statement Recognition
Sales-type lease — collectibility is probable (see Section 9.3.7.9)	Derecognize the net investment in the lease and measure the carrying value of the asset recognized on the basis of the net investment in the lease, less any impairments.	Recognize any ASC 310 or ASC 326 impairments.
Sales-type lease — collectibility is not probable (see Section 9.3.7.9)	Derecognize the deposit liability if the balance is nonrefundable to the lessee and either (1) the lease is terminated or (2) the lessor has repossessed the underlying asset and has no further obligation under the contract.	If the lessor can derecognize any deposit liability, recognize the amounts as selling profit.
Direct financing lease (see Section 9.3.8.6)	Derecognize the net investment in the lease and measure the carrying value of the asset recognized on the basis of the net investment in the lease, less any impairments.	Recognize any ASC 310 or ASC 326 impairments.
Operating lease	No impact.	No impact.

9.3.7 Sales-Type Lease

In a sales-type lease, the lessee gains control of the underlying asset and the lessor therefore relinquishes control to the lessee. Accordingly, the lessor derecognizes the underlying asset and in its place recognizes its new asset, the net investment in the lease (which consists of the sum of the lease receivable and the present value of the unguaranteed residual asset). Any selling profit or loss created as a result of the difference between those two amounts (net investment in the lease less carrying amount of asset) would be recognized at lease commencement. Initial direct costs would be recognized as an expense at lease commencement unless there is no selling profit or loss. If there is no selling profit or loss, the initial direct costs would be deferred and recognized over the lease term. In addition, the lessor would recognize interest income from the lease receivable over the lease term to reflect its new position with respect to the asset as a creditor of the “loan” provided to the customer (lessee).

Connecting the Dots

Sales-Type Leases When Fair Value Equals Carrying Value of the Underlying Asset

When the fair value of the asset subject to a sales-type lease is equal to its carrying value, the subsequent measurement is similar to the accounting for a direct financing lease because there is no gain (or loss) to immediately recognize. Therefore, all of the “income” associated with the lease is interest income (with no selling profit incorporated into the activity). Further, the initial direct costs are deferred (included in the net investment in the lease) and recognized over the term of the lease. This approach is the same as that used for direct financing leases.

In a manner consistent with ASC 606, if collectibility of the lease payments plus any lessee-provided residual value guarantee is not probable,11 the lessor would not record a sale. That is, the lessor would not derecognize the underlying asset and would account for lease payments received as a deposit liability until (1) collectibility of those amounts becomes probable or (2) the amounts received are nonrefundable and either the contract has been terminated or the lessor has repossessed the underlying asset. Once collectibility of those amounts becomes probable, the lessor would derecognize the underlying asset and recognize a net investment in the lease. If the contract has been terminated or the lessor has repossessed the underlying asset, and the amounts received are nonrefundable, the lessor would derecognize the deposit liability and recognize a corresponding amount of lease income.

9.3.7.1 Recognition, Initial Measurement, and Subsequent Measurement

9.3.7.1.1 Recognition and Initial Measurement

ASC 842-30

25-1 At the commencement date, a lessor shall recognize each of the following and derecognize the underlying asset in accordance with paragraph 842-30-40-1:

A net investment in the lease, measured in accordance with paragraph 842-30-30-1
Selling profit or selling loss arising from the lease
Initial direct costs as an expense if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. If the fair value of the underlying asset equals its carrying amount, initial direct costs (see paragraphs 842-10-30-9 through 30-10) are deferred at the commencement date and included in the measurement of the net investment in the lease. The rate implicit in the lease is defined in such a way that those initial direct costs eligible for deferral are included automatically in the net investment in the lease; there is no need to add them separately.

40-1 At the commencement date, a lessor shall derecognize the carrying amount of the underlying asset (if previously recognized) unless the lease is a sales-type lease and collectibility of the lease payments is not probable (see paragraph 842-30-25-3).

If collectibility for the sales-type lease is probable at lease commencement, the underlying asset is derecognized on the commencement date and a “net investment in the lease” is recognized. The difference between the net investment in the lease, or sales price, and the carrying value of the underlying asset must be recognized as selling profit or selling loss. See Section 9.3.7.2 for information on how to account for a sales-type lease when collectibility is not probable at lease commencement.

While ASC 842 indicates that selling loss could be recognized on the commencement date, lessors should ensure the completeness of their ASC 360 impairment analysis if they determine that a selling loss exists.

ASC 842-30

30-1 At the commencement date, for a sales-type lease, a lessor shall measure the net investment in the lease to include both of the following:

The lease receivable, which is measured at the present value, discounted using the rate implicit in the lease, of:
1. The lease payments (as described in paragraph 842-10-30-5) not yet received by the lessor
2. The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor
The unguaranteed residual asset at the present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease.

See Chapter 6 for more information on amounts included in and excluded from lease payments.

Connecting the Dots

Estimated Residual Value of Land

Under ASC 840, the estimated residual value of land in a sales-type or direct financing lease was limited to the land’s fair value determined at lease inception. While ASC 842 is silent on this issue, we believe that the same principle applies under ASC 842. That is, a lessor’s estimate of a land’s residual value in a sales-type or direct financing lease should be limited to the land’s fair value as of lease commencement. As a result, the land’s estimated residual value will never exceed the land’s fair value at lease commencement.

Any initial direct costs are recognized as an expense if, on the commencement date, the fair value of the underlying asset differs from the lessor’s carrying amount (see the Connecting the Dots discussion in Section 9.2.1.4.2 for considerations related to how lessors that are not manufacturers or dealers determine the fair value of the underlying asset). If the fair value of the underlying asset equals the carrying amount, initial direct costs are deferred on the commencement date and are included in the measurement of the net investment in the lease. See Section 6.11 for more information about what amounts constitute initial direct costs.

Changing Lanes

Narrower Definition of Initial Direct Costs

ASC 842 narrows the definition of initial direct costs. Previously, many lessors capitalized amounts related to overhead from their leasing departments (e.g., employees’ salaries in that department). Because such costs would be incurred regardless of whether a lease was executed, lessors will be prohibited from capitalizing them as a result of this narrower definition.

9.3.7.1.2 Subsequent Measurement

ASC 842-30

25-2 After the commencement date, a lessor shall recognize all of the following:

Interest income on the net investment in the lease, measured in accordance with paragraph 842-30-35-1(a)
Variable lease payments that are not included in the net investment in the lease as income in profit or loss in the period when the changes in facts and circumstances on which the variable lease payments are based occur . . . .

While selling profit is recognized in a sales-type lease at lease commencement, it is also necessary to recognize interest income for the financing provided by the lessor (i.e., to reflect that, through the contract, the lessor has effectively converted the leased asset into a financial asset).

ASC 842-30

35-1 After the commencement date, a lessor shall measure the net investment in the lease by doing both of the following:

Increasing the carrying amount to reflect the interest income on the net investment in the lease. A lessor shall determine the interest income on the net investment in the lease in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease.
Reducing the carrying amount to reflect the lease payments collected during the period.

35-2 After the commencement date, a lessor shall not remeasure the net investment in the lease unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.

Interest income should generally be recognized during all reporting periods, regardless of payment timing. Any interest income not yet paid would be included as an increase in the basis of the net investment in the lease. The rate the lessor uses should be a constant periodic discount rate with respect to the remaining balance of the net investment in the lease (i.e., the lessor should subsequently measure the net investment in the lease by using the effective interest method and the rate implicit in the lease).

Because variable lease payments are not included in the net investment in the lease, any amounts receivable or received (allocated to the lease component) must be recognized as income in the period in which the changes in facts and circumstances on which the variable lease payments are based occur. See Chapter 6 for more information on how to identify whether a lease payment is variable and Section 4.4.2.2.1 for a discussion about recognizing variable payments for which a portion is attributable to a nonlease component.

The scenario below, reprinted from Example 1 in ASC 842-30-55, illustrates a lessor’s accounting for a sales-type lease.

ASC 842-30

30-3 See Example 1 (paragraphs 842-30-55-18 through 55-43) for an illustration of the requirements for sales-type . . . leases.

Illustration of Lessor Accounting

55-18 Example 1 illustrates how a lessor would account for sales-type leases and direct financing leases.

Example 1 — Lessor Accounting Example

Case A — Lessor Accounting — Sales-Type Lease

55-19 Lessor enters into a 6-year lease of equipment with Lessee, receiving annual lease payments of $9,500, payable at the end of each year. Lessee provides a residual value guarantee of $13,000. Lessor concludes that it is probable it will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by Lessee. The equipment has a 9-year estimated remaining economic life, a carrying amount of $54,000, and a fair value of $62,000 at the commencement date. Lessor expects the residual value of the equipment to be $20,000 at the end of the 6-year lease term. The lease does not transfer ownership of the underlying asset to Lessee or contain an option for Lessee to purchase the underlying asset. Lessor incurs $2,000 in initial direct costs in connection with obtaining the lease, and no amounts are prepaid by Lessee to Lessor. The rate implicit in the lease is 5.4839 percent.

55-20 Lessor classifies the lease as a sales-type lease because the sum of the present value of the lease payments and the present value of the residual value guaranteed by the lessee amounts to substantially all of the fair value of the equipment. None of the other criteria to be classified as a sales-type lease are met. In accordance with paragraph 842-10-25-4, the discount rate used to determine the present value of the lease payments and the present value of the residual value guaranteed by Lessee (5.4839 percent) for purposes of assessing whether the lease is a sales-type lease under the criterion in paragraph 842-10-25-2(d) assumes that no initial direct costs will be capitalized because the fair value of the equipment is different from its carrying amount.

55-21 Lessor measures the net investment in the lease at $62,000 at lease commencement, which is equal to the fair value of the equipment. The net investment in the lease consists of the lease receivable (which includes the 6 annual payments of $9,500 and the residual value guarantee of $13,000, both discounted at the rate implicit in the lease, which equals $56,920) and the present value of the unguaranteed residual value (the present value of the difference between the expected residual value of $20,000 and the residual value guarantee of $13,000, which equals $5,080). Lessor calculates the selling profit on the lease as $8,000, which is the difference between the lease receivable ($56,920) and the carrying amount of the equipment net of the unguaranteed residual asset ($54,000 – $5,080 = $48,920). The initial direct costs do not factor into the calculation of the selling profit in this Example because they are not eligible for deferral on the basis of the guidance in paragraph 842-30-25-1(c) (that is, because the fair value of the underlying asset is different from its carrying amount at the commencement date).

55-22 At the commencement date, Lessor derecognizes the equipment (carrying amount of $54,000) and recognizes the net investment in the lease of $62,000 and the selling profit of $8,000. Lessor also pays and recognizes the initial direct costs of $2,000 as an expense.

55-23 At the end of Year 1, Lessor recognizes the receipt of a lease payment of $9,500 and interest on the net investment in the lease (the beginning balance of the net investment in the lease of $62,000 × the rate implicit in the lease of 5.4839% = $3,400), resulting in a balance in the net investment of the lease of $55,900. For disclosure purposes, Lessor also calculates the separate components of the net investment in the lease: the lease receivable and the unguaranteed residual asset. The lease receivable equals $50,541 (the beginning balance of the lease receivable of $56,920 – the annual lease payment received of $9,500 + the amount of interest income on the lease receivable during Year 1 of $3,121, which is $56,920 × 5.4839%). The unguaranteed residual asset equals $5,360 (the beginning balance of the unguaranteed residual asset of $5,081 + the interest income on the unguaranteed residual asset during Year 1 of $279, which is $5,081 × 5.4839%).

55-24 At the end of Year 6, Lessor reclassifies the net investment in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment.

Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record.

Step 1: Gather the Facts

Lease term: 6 years.
Lease payments: $9,500/year beginning at the end of year 1.
Residual value guarantee provided by lessee: $13,000.
Collectibility of the lease payments and residual value guarantee as of commencement is probable.
Economic life of equipment: 9 years.
Carrying amount: $54,000.
Fair value: $62,000.
Expected residual value at end of term: $20,000.
No transfer of ownership and no purchase options.
Lessor incurs $2,000 in initial direct costs.

Step 2: Determine the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate so that the sum equals the fair value of the asset. Because the fair value of the asset differs from the carrying value, the initial direct costs are not included in the calculation of the rate implicit in the lease (since such amounts are immediately expensed).

Step 3: Determine the Lease Classification

The lessor would apply the criteria in ASC 842-10-25-2 to determine whether the lease should be classified as a sales-type lease:

Because the lease meets the criterion in ASC 842-10-25-2(d), the lessor determines that the lease is a sales-type lease.

Step 4: Record the Commencement-Date Journal Entries

Because control of the asset was lost, the lessor must derecognize the asset and record the net investment in the lease.

The net investment in the lease is measured as the present value of the sum of the (1) lease payments not yet received by the lessor, (2) residual value guaranteed by the lessee or a third party unrelated to the lessor, and (3) residual value that is not guaranteed by the lessee or a third party unrelated to the lessor. The lessor determines the present value of the lease payments not yet received as $47,482, and the present value of the residual asset that is guaranteed and unguaranteed that the lessor expects to receive is $14,518 ($9,437 and $5,081, respectively). The net investment in the lease is therefore $62,000 (or the fair value of the underlying asset), as reflected in the following journal entry:

The difference between the net investment in the lease and the carrying value of the underlying asset is recognized as selling profit at lease commencement. Because the fair value of the underlying asset differs from the carrying amount of the underlying asset as of the commencement date, initial direct costs are not eligible for deferral:

Step 5: Record the Activities Related to the Sales-Type Lease

In year 1, the lessee pays the lessor $9,500. A portion of the payment is allocable to interest income, since the lessor is effectively financing the lessee’s purchase. The interest income is recognized as $3,400 ($62,000 × 5.4839%). Note that this income should be recognized over the reporting period and is not governed by when the amount is paid by the lessee. The other portion of the lessee’s payment results in a reduction in the lessor’s net investment in the lease (which represents the receivable from the lessee). Embedded within the interest income (and related increase in the net investment in the lease) is the accretion of the unguaranteed residual value of the asset.

The remainder of the cash payments received over the life of the lease should be recognized as follows through year 6:

Step 6: Record the Return of the Underlying Asset to the Lessor

The ending net investment in the lease represents the estimated value the lessor will receive from the lessee when the lessor regains control over the underlying asset. The balance of the net investment in the lease will equal the expected value of the residual asset estimated at commencement (less any impairments). Note no increases in the expected underlying value of the asset should be recognized during the lease term. The lessor would record the following journal entry to reflect the return of the underlying asset at the residual value expected at the end of the lease term:

Connecting the Dots

Commencement Loss Resulting From a Significant Variable Payment in a Sales-Type or Direct Financing Lease (Before the Adoption of ASU 2021-05)

While the FASB’s goal was to align lessor accounting with the revenue guidance in ASC 606, an important distinction between the two may affect lessors in a number of industries. 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 recognition of 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.

In line with views the FASB expressed at it’s November 30, 2016, meeting, a lessor should recognize a loss at lease commencement when its initial measurement of the net investments in a sales-type or direct financing lease is less than the current value of the underlying asset. The Board acknowledged that a lessor’s initial measurement of a sales-type or direct financing lease that includes a significant variable-lease payment component may result in a loss at lease commencement if the lease receivable plus the unguaranteed residual asset is less than the net carrying value of the underlying asset being leased. The Board discussed whether a loss at commencement would be appropriate in these situations or whether other possible approaches would be acceptable, such as (1) incorporating variable lease payments subject to a constraint (by reference to ASC 606) or (2) using a negative discount rate to avoid the loss at commencement. The Board expressed its belief that while stakeholders may disagree with the outcome of recognizing a loss at commencement, ASC 842 is clear on how the initial measurement guidance should be applied to sales-type and direct financing leases.

In discussions with the FASB staff, we observed that in situations similar to those outlined in Examples 9-12 and 9-13, 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 842-30-20) is inappropriate.12 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.

Changing Lanes

Issuance of ASU 2021-05

In July 2021, the FASB issued ASU 2021-05, which amends a lessor’s accounting for leases that contain variable lease payments and that result in a day 1 loss. See Section 17.3.1.8 for more information.

Example 9-12

A lessee and manufacturer lessor enter into a five-year sales-type lease of the lessor’s R2-series equipment. Before lease commencement, the lessor customizes the R2-series equipment specifically for the lessee.13 The asset has a carrying value of $100, a fair value at commencement of $120, and an estimated unguaranteed residual value of $50 at the end of the lease term. Payments are based entirely on the lessee’s usage of the R2-series equipment. The lessor has significant insight into the lessee’s equipment needs over the five-year term, and although the payments are 100 percent variable, the lessor has priced the lease with the expectation that it will receive an annual payment of $20. The lessor thus charges the lessee a rate of 6.4 percent.14

The tables below illustrate the terms of the sales-type lease and the lessor’s accounting for the lease under ASC 842.

Example 9-13

Assume the same facts as in Example 9-12. The lessor still charges the lessee a rate of 6.4 percent based on expected annual cash flows of $20.15 However, the lessor prices the lease with 50 percent of the cash flows fixed and 50 percent of the cash flows variable based on the lessee’s usage of the R2-series equipment.

The tables below illustrate the terms of the sales-type lease and the lessor’s accounting for the lease under ASC 842.

Connecting the Dots

Arrangements With Significant Variable Lease Payments (Before the Adoption of ASU 2021-05)

It is common for lease arrangements in a number of industries to include significant or wholly variable lease payments. It is not uncommon for such arrangements to result in sales-type or direct financing lease classification.

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). The lessor would account for the arrangement as a sale-type lease if the lease (1) is for a major part of the economic life of the retail location or (2) contains a purchase option that the lessee is reasonably certain to exercise. 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.

9.3.7.2 Accounting for Lack of Collectibility

ASC 842-30

25-3 The guidance in paragraphs 842-30-25-1 through 25-2 notwithstanding, if collectibility of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, is not probable at the commencement date, the lessor shall not derecognize the underlying asset but shall recognize lease payments received — including variable lease payments — as a deposit liability until the earlier of either of the following:

Collectibility of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, becomes probable. If collectibility is not probable at the commencement date, a lessor shall continue to assess collectibility to determine whether the lease payments and any amount necessary to satisfy a residual value guarantee are probable of collection.
Either of the following events occurs:
1. The contract has been terminated, and the lease payments received from the lessee are nonrefundable.
2. The lessor has repossessed the underlying asset, it has no further obligation under the contract to the lessee, and the lease payments received from the lessee are nonrefundable.

As indicated above, the lessor would not derecognize the underlying asset if collectibility is not probable as of the commencement date; instead, in such circumstances, any proceeds would be recognized as a deposit liability. See Section 9.3.7.3 for information on accounting for changes in collectibility.

Changing Lanes

Lack of Collectibility Results in More Restrictive Recognition

If the collection of lease payments was not reasonably predictable under ASC 840, the lease may not have been classified as a sales-type lease. Nonetheless, the lease payments may have been recognized in profit or loss under the operating lease model. In an identical scenario in which a lease meets all of the ASC 842 sales-type criteria, a lessor would be required to record any payments received as a deposit liability and income recognition would be delayed. Because ASC 842 would still require the lease to be classified as a sales-type lease (not as an operating lease, as would have been required under ASC 840) despite the collectibility concerns, a lessor would not be able to recognize lease payments in profit or loss as quickly as it did under ASC 840.

9.3.7.3 When Collectibility Becomes Probable

ASC 842-30

25-4 When collectibility is not probable at the commencement date, at the date the criterion in paragraph 842-30-25-3(a) is met (that is, the date at which collectibility of the lease payments plus any amount necessary to satisfy a residual value guarantee provided by the lessee is assessed as probable), the lessor shall do all of the following:

Derecognize the carrying amount of the underlying asset
Derecognize the carrying amount of any deposit liability recognized in accordance with paragraph 842-30-25-3
Recognize a net investment in the lease on the basis of the remaining lease payments and remaining lease term, using the rate implicit in the lease determined at the commencement date
Recognize selling profit or selling loss calculated as:
1. The lease receivable; plus
2. The carrying amount of the deposit liability; minus
3. The carrying amount of the underlying asset, net of the unguaranteed residual asset.

25-5 When collectibility is not probable at the commencement date, at the date the criterion in paragraph 842-30-25-3(b) is met, the lessor shall derecognize the carrying amount of any deposit liability recognized in accordance with paragraph 842-30-25-3, with the corresponding amount recognized as lease income.

25-6 If collectibility is probable at the commencement date for a sales-type lease or for a direct financing lease, a lessor shall not reassess whether collectibility is probable. Subsequent changes in the credit risk of the lessee shall be accounted for in accordance with the credit loss guidance applicable to the net investment in the lease in paragraph 842-30-35-3.

Changes in collectibility after lease commencement do not affect the lease’s classification but do affect subsequent measurement. If collectibility is not probable at lease commencement, no sale is recognized. However, if collectibility of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, does become probable during the lease term, the lessor may recognize the sale at such time. Further, at such time, the lessor must derecognize the carrying amount of the underlying asset, as well as any deposit liability, and must recognize a net investment in the lease. The lessor should measure the net investment in the lease as the present value of the remaining lease payments, discounting the payments by using the rate implicit in the lease. The difference between these amounts is recorded as selling profit or loss.

The scenario below, reprinted from Example 1 in ASC 842-30-55, illustrates the lessor’s accounting for a sales-type lease when collectibility of the lease payments is not probable. Certain facts in this scenario are the same as those in Case A of Example 1, which is reproduced in Section 9.3.7.1.

ASC 842-30

Case B — Lessor Accounting — Sales-Type Lease — Collectibility of the Lease Payments Is Not Probable

55-25 Assume the same facts and circumstances as in Case A (paragraphs 842-30-55-19 through 55-24), except that it is not probable Lessor will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by Lessee. In reaching this conclusion, the entity observes that Lessee’s ability and intention to pay may be in doubt because of the following factors:

Lessee intends to make the lease payments primarily from income derived from its business in which the equipment will be used (which is a business facing significant risks because of high competition in the industry and Lessee’s limited experience)
Lessee has limited credit history and no significant other income or assets with which to make the payments if the business is not successful.

55-26 In accordance with paragraph 842-30-25-3, Lessor does not derecognize the equipment and does not recognize a net investment in the lease or any selling profit or selling loss. However, consistent with Case A, Lessor pays and recognizes the initial direct costs of $2,000 as an expense at the commencement date.

55-27 At the end of Year 1, Lessor reassesses whether it is probable it will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by Lessee and concludes that it is not probable. In addition, neither of the events in paragraph 842-30-25-3(b) has occurred. The contract has not been terminated and Lessor has not repossessed the equipment because Lessee is fulfilling the terms of the contract. Consequently, Lessor accounts for the $9,500 Year 1 lease payment as a deposit liability in accordance with paragraph 842-30-25-3. Lessor recognizes depreciation expense on the equipment of $7,714 ($54,000 carrying value ÷ 7-year useful life).

55-28 Lessor’s accounting in Years 2 and 3 is the same as in Year 1. At the end of Year 4, Lessee makes the fourth $9,500 annual lease payment such that the deposit liability equals $38,000. Lessor concludes that collectibility of the lease payments and any amount necessary to satisfy the residual value guarantee provided by Lessee is now probable on the basis of Lessee’s payment history under the contract and the fact that Lessee has been successfully operating its business for four years. Lessor does not reassess the classification of the lease as a sales-type lease.

55-29 Consequently, at the end of Year 4, Lessor derecognizes the equipment, which has a carrying amount of $23,143, and recognizes a net investment in the lease of $35,519. The net investment in the lease consists of the lease receivable (the sum of the 2 remaining annual payments of $9,500 and the residual value guarantee of $13,000, discounted at the rate implicit in the lease of 5.4839 percent determined at the commencement date, which equals $29,228) and the unguaranteed residual asset (the present value of the difference between the expected residual value of $20,000 and the residual value guarantee of $13,000, which equals $6,291). Lessor recognizes selling profit of $50,376, the difference between (a) the sum of the lease receivable and the carrying amount of the deposit liability ($29,228 lease receivable + $38,000 in lease payments already made = $67,228) and (b) the carrying amount of the equipment, net of the unguaranteed residual asset ($23,143 – $6,291 = $16,852).

55-30 After the end of Year 4, Lessor accounts for the remaining two years of the lease in the same manner as any other sales-type lease. Consistent with Case A, at the end of Year 6, Lessor reclassifies the net investment in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment.

Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record.

Step 1: Gather the Facts

Lease term: 6 years.
Lease payments: $9,500/year beginning at the end of year 1.
Residual value guarantee provided by lessee: $13,000.
Collection of the lease payments and residual value guarantee as of commencement is not probable but becomes probable at the end of year 4.
Economic life of equipment: 7 years.16
Carrying amount: $54,000.
Fair value: $62,000.
Expected residual value at end of term: $20,000.
No transfer of ownership and no purchase options.
Lessor incurs $2,000 in initial direct costs.

Step 2: Solve for the Rate Implicit in the Lease

All else being equal, the rate implicit in the lease would be unchanged by the collectibility assessment, although the rate of return would be expected to be higher in situations in which collectibility is in doubt than in arrangements in which collectibility is probable. As in Case A above (see Section 9.3.7.1), the implicit rate in the lease in this scenario is 5.4839 percent.

Step 3: Determine the Lease Classification

None of the lease classification criteria for a sales-type lease require a lessor to consider collectibility. Therefore, the change in fact (i.e., it is not probable at commencement that the lease payments are collectible) has no impact on the sales-type lease classification.

Step 4: Record the Commencement-Date Journal Entries

Because of the collectibility concerns, a sale has not occurred and the only entry that the lessor records at lease commencement is to recognize the initial direct costs. The fair value of the underlying asset differs from the carrying amount of the underlying asset as of the commencement date; thus, initial direct costs are not eligible for deferral. The following entry would be recorded:

Step 5: Record the Activities Related to the Sales-Type Lease

In year 1, the lessee must pay the lessor $9,500. The lessor determines that collectibility is not yet probable. The lease contract has not been terminated, and the lessor has not repossessed the underlying asset. Consequently, the lessor accounts for the $9,500 payment as a deposit liability:

Moreover, since the underlying asset was not derecognized because sale accounting was not achieved, the lessor should recognize depreciation expense on the basis of the remaining useful life (7 years) and the carrying value of the underlying asset, $54,000:

In years 2 and 3, (1) the lessor maintains its assessment that collectibility is not yet probable, (2) the lease contract has not been terminated, and (3) the lessor has not repossessed the underlying asset. Balances and activities are recognized as shown below.

At the end of year 4, the lessee completes its fourth $9,500 payment; thus, the deposit liability is $38,000 ($28,500 + $9,500). Contemporaneously, the lessor concludes that collectibility of the payments and any amount necessary to satisfy the residual value guarantee provided by the lessee is now probable. Classification is not revisited.

Because a sale has occurred, the lessor must derecognize the asset and record the net investment in the lease. In calculating the “net investment in the lease,” the lessor determines that the present value of the lease payments not yet received is $17,544. The present value of the residual asset that is guaranteed and unguaranteed that the lessor expects to receive is $17,975. The net investment in the lease is therefore $35,519.

The lessor would recognize, as selling profit, the difference between (1) the net investment in the lease, the deposit liability, and the cash received for the fourth payment and (2) the carrying value of the underlying asset. The selling profit is recognized as of the date collectibility becomes probable.

As shown below, the lease receivable is subsequently measured as it was in Case A.

Step 6: Record the Return of the Underlying Asset to the Lessor

The ending net investment in the lease represents the amount the lessor will receive from the lessee when the lessor regains control over the underlying asset. The entry to reflect the return of the underlying asset at the residual value expected at the end of the lease term is depicted below.

9.3.7.4 Collectibility Is Probable at Commencement — Subsequent Changes in Credit Risk

ASC 842-30

Changes in the lessee’s credit risk after lease commencement are accounted for in accordance with the impairment guidance discussed in the next section.

9.3.7.5 Impairment

ASC 842-30

25-2 After the commencement date, a lessor shall recognize all of the following: . . .

c. Credit losses on the net investment in the lease (as described in paragraph 842-30-35-3).

35-3 A lessor shall determine the loss allowance related to the net investment in the lease and shall record any loss allowance in accordance with Subtopic 326-20 on financial instruments measured at amortized cost. When determining the loss allowance for a net investment in the lease, a lessor shall take into consideration the collateral relating to the net investment in the lease. The collateral relating to the net investment in the lease represents the cash flows that the lessor would expect to receive (or derive) from the lease receivable and the unguaranteed residual asset during and following the end of the remaining lease term.

The net investment in the lease must be monitored for impairment in accordance with ASC 310 or — after the adoption of ASU 2016-13 — ASC 326, which introduces the CECL model that is based on expected losses rather than historical incurred losses. See Section 5.3 of Deloitte’s Roadmap Current Expected Credit Losses for further discussion of the application of the CECL model to lease receivables.

When evaluating the net investment in a sales-type or direct financing lease for impairment, a lessor should apply the guidance in ASC 842-30-35-3, which indicates that a lessor should use the cash flows it expects to derive from the “lease receivable and the unguaranteed residual asset during and following the end of the remaining lease term.” Accordingly, the unit of account used when the impairment model is applied from the lessor’s perspective is meant to encompass amounts related to the entire net investment in the lease, which would include the residual asset, and the cash flows in impairment testing would include those that the lessor expects to derive from the underlying asset at the end of the lease term. When determining the cash flows to be derived from the underlying asset at the end of the lease term, a lessor should consider amounts it would receive for re-leasing or selling the underlying asset to a third party but should not consider the expected credit risk of the potential lessee or buyer of the underlying asset (i.e., it would not be appropriate for the lessor to include a credit risk assumption in its analysis since it does not know the identity of the theoretical buyer).

Because impairment of the net investment in the lease is recognized in accordance with ASC 310 (or ASC 326, if adopted), any deterioration in the credit quality of the lessee must be reflected in the impairment recognized. Note that after lease commencement, changes in collectibility do not affect the classification of the lease. When measuring the impairment of the net investment in the lease, the lessor should consider the collateral (underlying asset) to be a cash flow that it would expect to derive from the underlying asset, including cash flows expected to be derived after the end of the lease term. In other words, amounts expected to be earned from re-leasing the asset would be considered. When using a discounted cash flow approach to measure impairment related to the net investment in leases, the lessor should employ the rate implicit in the lease.

Changing Lanes

ASC 842 Introduces Single Asset Impairment Model

Under ASC 840, a lessor was required to assess the net investment in the lease for impairments by assessing (1) the lease receivable in accordance with ASC 310 and (2) the unguaranteed residual asset in accordance with ASC 360. However, the FASB did not carry forward the dual model for assessing impairment of the net investment in the lease. In paragraphs BC310 and BC311 of ASU 2016-02, the FASB indicates that including two impairment models is overly complex and would result in financial statement information whose benefits would not justify its costs. Moreover, the Board notes that the net investment in a lease primarily comprises a financial lease receivable (i.e., the unguaranteed residual asset is often insignificant) and therefore should be accounted for as a financial asset under ASC 310.

Issuance of ASU 2016-13

In June 2016, the FASB issued ASU 2016-13, which supersedes ASC 310 and therefore changes how lessors measure impairment in the net investment in the lease. Under ASU 2016-13, lessors with net investments in leases are required to recognize an allowance for credit losses. For PBEs that meet the definition of an SEC filer, the guidance in the ASU became effective for annual periods beginning after December 15, 2019 (i.e., calendar periods beginning after January 1, 2020), and interim periods therein. For all other entities, the guidance is effective for annual periods beginning after December 15, 2022 (i.e., calendar periods beginning after January 1, 2023), and interim periods therein. Early adoption was permitted for all entities as of fiscal years beginning after December 15, 2018, and interim periods therein.

9.3.7.6 Sale of Lease Receivable

ASC 842-30

35-4 If a lessor sells substantially all of the lease receivable associated with a sales-type lease or a direct financing lease and retains an interest in the unguaranteed residual asset, the lessor shall not continue to accrete the unguaranteed residual asset to its estimated value over the remaining lease term. The lessor shall report any remaining unguaranteed residual asset thereafter at its carrying amount at the date of the sale of the lease receivable and apply Topic 360 on property, plant, and equipment to determine whether the unguaranteed residual asset is impaired.

If a lessor sells a lease receivable, an entity should consider the guidance in ASC 860 to determine whether the transfer of a financial asset (i.e., the lease receivable) has occurred and may be derecognized. However, such guidance does not address how the lessor should account for the sale of a sales-type lease receivable when it retains an interest in the unguaranteed residual asset. If the lessor retains an interest in the unguaranteed residual asset, this asset would no longer be accreted to its estimated value over the lease term. Instead, the lessor would keep the asset at its carrying value, less any necessary impairments determined in accordance with ASC 360.

ASC 842-40

Determining Whether the Transfer of the Asset Is a Sale

25-1 An entity shall apply the following requirements in Topic 606 on revenue from contracts with customers when determining whether the transfer of an asset shall be accounted for as a sale of the asset:

Paragraphs 606-10-25-1 through 25-8 on the existence of a contract
Paragraph 606-10-25-30 on when an entity satisfies a performance obligation by transferring control of an asset.

To gain liquidity, a lessor may enter into a transaction to sell its interest in lease receivables. In addition to the receivable itself, the lessor may sell its interest in the unguaranteed residual asset; from an accounting perspective, the lessor would have already derecognized the underlying asset as part of its leasing transaction. ASC 842 does not indicate how to account for the sale of an unguaranteed residual asset in a sales-type lease. An entity should consider ASC 842-40-25-1 in evaluating whether the sale and derecognition of the unguaranteed residual value of the asset are appropriate. For more information, see Deloitte’s Roadmap Revenue Recognition.

9.3.7.7 Lease Modification

9.3.7.7.1 Modified Lease Is a Sales-Type or Direct Financing Lease

ASC 842-10

25-17 If a sales-type lease is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8, the lessor shall account for the modified lease as follows: . . .

If the modified lease is classified as a sales-type or a direct financing lease, in the same manner as described in paragraph 842-10-25-16(a) . . . .

25-16 . . .

[T]he lessor shall adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease immediately before the effective date of the modification. . . .

35-6 A lessor shall not remeasure the lease payments unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.

Upon concluding that a lease modification has occurred and that the modification is not accounted for as a separate contract (see Section 9.3.4), the lessor should adjust the discount rate so that the present value of the lease payments equals the carrying value of the net investment in the lease as of the effective date. In performing this calculation, the lessor should remeasure the lease payments as necessary. For example, if the lease payments included an amount that was a variable payment based on an index or rate, the lessor would reset the amount that it previously used in its calculation. Effectively, no additional selling profit would be recognized as a result of the modification; however, the amount of interest income that is recognized prospectively could change (because of the change in the discount rate). Note that a negative discount rate cannot be used and that a lessor should consider whether its net investment in the lease is impaired.

Connecting the Dots

Modification From Fixed Lease Payments to Variable Lease Payments

Lessors may need to consider circumstances in which lease payments are modified so that they become variable (after being previously fixed). In such circumstances, the lessor may need to consider whether the lease classification would be modified to that of an operating lease in accordance with the guidance in ASU 2021-05. We encourage lessors to consult with their auditors and accounting advisers on this topic.

9.3.7.7.2 Modified Lease Is an Operating Lease

ASC 842-10

b. If the modified lease is classified as an operating lease, in the same manner as described in paragraph 842-10-25-16(c).

25-16 . . .

c. If the modified lease is classified as an operating lease, the carrying amount of the underlying asset equals the net investment in the original lease immediately before the effective date of the modification.

As noted in ASC 842-10-25-16, if a sales-type lease is modified in such a way that the lease is classified as an operating lease, ”the carrying amount of the underlying asset equals the net investment in the original lease immediately before the effective date of the modification.” The subsequent measurement of the underlying asset should be accounted for in accordance with ASC 360, and the balance should be classified in the appropriate category of assets.

9.3.7.8 Lease Termination

ASC 842-30

40-2 If a sales-type lease or a direct financing lease is terminated before the end of the lease term, a lessor shall do all of the following:

Measure the net investment in the lease for credit losses in accordance with Subtopic 326-20 on financial instruments measured at amortized cost and record any credit loss identified
Reclassify the net investment in the lease to the appropriate category of asset in accordance with other Topics, measured at the sum of the carrying amounts of the lease receivable (less any amounts still expected to be received by the lessor) and the residual asset
Account for the underlying asset that was the subject of the lease in accordance with other Topics.

If a sales-type lease is terminated before the end of the lease term, the net investment in the lease must be tested for impairment and reclassified in the manner described above. The underlying asset must then be subsequently measured in accordance with ASC 360.

ASC 842-30

40-3 If the original lease agreement is replaced by a new agreement with a new lessee, the lessor shall account for the termination of the original lease as provided in paragraph 842-30-40-2 and shall classify and account for the new lease as a separate transaction.

40-4 For guidance on the acquisition of the residual value of an underlying asset by a third party, see paragraph 360-10-25-2.

9.3.7.9 End of Lease Term

ASC 842-30

35-5 At the end of the lease term, a lessor shall reclassify the net investment in the lease to the appropriate category of asset (for example, property, plant, and equipment) in accordance with other Topics, measured at the carrying amount of the net investment in the lease. The lessor shall account for the underlying asset that was the subject of a lease in accordance with other Topics.

At commencement, the net investment in the lease is recognized, including the expected residual value of the asset (on either a guaranteed or an unguaranteed basis), at the net investment’s then present value. At the end of the lease, the net investment in the lease should have been accreted to its estimated fair value as determined at lease commencement (i.e., no gains will be recognized as a result of the increase in the asset’s fair value); when this balance is removed, the asset recorded should reflect the balance of the net investment in the lease at the end of the lease.

9.3.7.10 Definition of the “Carrying Amount”

In the determination of the value at which a lessor should record a previously leased asset upon the completion or termination of a sales-type lease, the “carrying amount” of the asset is the carrying value of the lessor’s net investment in the lease at the time of termination, including impairments, even though that amount may exceed the depreciated cost of the asset that would have been recorded by the lessee.

9.3.8 Direct Financing Lease

In a direct financing lease, the lessee does not individually obtain control of the asset but the lessor does relinquish control. This would occur, for example, if (1) the present value of the lease payments and any residual value guarantee (which could be provided entirely by a third party or consist of a lessee guarantee coupled with a third-party guarantee) represents substantially all of the fair value of the underlying asset and (2) it is probable that the lessor will collect the lease payments and any amounts related to the residual value guarantee(s). In a direct financing lease (in a manner consistent with a sales-type lease), the lessor derecognizes the underlying asset and recognizes a net investment in the lease (which consists of the lease receivable and unguaranteed residual asset). However, unlike the lessor in a sales-type lease, the lessor in a direct financing lease defers profit and amortizes it as interest income over the lease term. As a result, in a direct financing lease, there is no gain recognition in the income statement upon lease commencement.

9.3.8.1 Recognition, Initial Measurement, and Subsequent Measurement

ASC 842-30

25-7 At the commencement date, a lessor shall recognize both of the following and derecognize the underlying asset in accordance with paragraph 842-30-40-1:

A net investment in the lease, measured in accordance with paragraph 842-30-30-2
Selling loss arising from the lease, if applicable.

30-2 At the commencement date, for a direct financing lease, a lessor shall measure the net investment in the lease to include the items in paragraph 842-30-30-1(a) through (b), reduced by the amount of any selling profit.

As noted in Section 9.2.2.1.2, for the classification criteria to be met for a direct financing lease, collection of the lease payments and any residual value guarantee must be probable. In a sales-type lease, however, collectibility is considered when the sale is evaluated for recognition, not during classification.

In a direct financing lease, the underlying asset is derecognized, and the net investment in the lease is recognized, as of the commencement date. If the net investment in the lease is less than the carrying value of the underlying asset, a selling loss should be immediately recognized. If the net investment in the lease is greater than the carrying value, the difference (i.e., the selling profit) should be offset against the net investment in the lease and there would therefore be no recognition in profit and loss. In paragraph BC97 of ASU 2016-02, the FASB addresses why it would be inconsistent with the principle of direct financing leases (i.e., financings) to recognize selling profit at commencement:

If a direct financing lease gives rise to selling profit (which the Board understands to be infrequent), a lessor does not recognize the selling profit at lease commencement, reducing the lessor’s net investment in the lease. A lessor then recognizes the profit over the lease term in such a manner so as to produce, when combined with the interest income on the remainder of the net investment (that is, the lease receivable and the unguaranteed residual asset), a constant periodic rate of return on the lease. A direct financing lessor recognizes selling profit in this manner over the lease term because that accounting reflects that the lessor generally prices the lease to achieve a reasonable return on its investment in the underlying asset and would not position itself to incur a loss on disposition of the residual asset after the end of the lease.

ASC 842-30

25-8 Selling profit and initial direct costs (see paragraphs 842-10-30-9 through 30-10) are deferred at the commencement date and included in the measurement of the net investment in the lease. The rate implicit in the lease is defined in such a way that initial direct costs deferred in accordance with this paragraph are included automatically in the net investment in the lease; there is no need to add them separately.

30-1 At the commencement date . . . a lessor shall measure the net investment in the lease to include both of the following:

The lease receivable, which is measured at the present value, discounted using the rate implicit in the lease, of:
1. The lease payments (as described in paragraph 842-10-30-5) not yet received by the lessor
2. The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor
The unguaranteed residual asset at the present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease.

See Chapter 6 for more information on amounts included in and excluded from lease payments.

In a direct financing lease, any initial direct costs are included in the net investment in the lease (and therefore are deferred). Note that there is no need to add these amounts separately, since they are included in the rate implicit in the lease. In other words, when calculating the implicit rate in the lease, the lessor includes the outflow of initial direct costs in the initial cash outflow. Therefore, when the lessor recognizes the interest income over the term of the lease, the rate incorporates the recognition of initial direct costs.

ASC 842-30

25-9 After the commencement date, a lessor shall recognize all of the following:

Interest income on the net investment in the lease, measured in accordance with paragraph 842-30-35-1(a)
Variable lease payments that are not included in the net investment in the lease as income in profit or loss in the period when the changes in facts and circumstances on which the variable lease payments are based occur . . . .

In a direct financing lease, interest income is earned over the lease term and is recognized during all reporting periods, regardless of whether the payment is received at such times. Any profit (an excess of the net investment in the lease over the carrying value of the underlying asset) is recognized through interest income, since the lessor is not “selling” the asset (according to the classification tests) but is providing financing to the lessee for its lease investment.

ASC 842-30

35-1 After the commencement date, a lessor shall measure the net investment in the lease by doing both of the following:

Increasing the carrying amount to reflect the interest income on the net investment in the lease. A lessor shall determine the interest income on the net investment in the lease in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease.
Reducing the carrying amount to reflect the lease payments collected during the period.

The commencement-date measurement considerations in ASC 842-30-35-1 that apply to sales-type leases also apply to direct financing leases. See Section 9.3.7.1 for more information.

The scenario below, reprinted from Example 1 in ASC 842-30-55, illustrates the accounting for a direct financing lease.

ASC 842-30

Case C — Lessor Accounting — Direct Financing Lease

55-31 Assume the same facts and circumstances as in Case A (paragraphs 842-30-55-19 through 55-24), except that the $13,000 residual value guarantee is provided by a third party, not by Lessee. Collectibility of the lease payments and any amount necessary to satisfy the third-party residual value guarantee is probable.

55-32 None of the criteria in paragraph 842-10-25-2 to be classified as a sales-type lease are met. In accordance with paragraph 842-10-25-4, the discount rate used to determine the present value of the lease payments (5.4839 percent) for purposes of assessing whether the lease is a sales-type lease under the criterion in paragraph 842-10-25-2(d) assumes that no initial direct costs will be capitalized because the fair value of the equipment is different from its carrying amount.

55-32A Rather, Lessor classifies the lease as a direct financing lease because the sum of the present value of the lease payments and the present value of the residual value guaranteed by the third party amounts to substantially all of the fair value of the equipment, and it is probable that Lessor will collect the lease payments plus any amount necessary to satisfy the third-party residual value guarantee. The discount rate used to determine the present value of the lease payments and the present value of the third-party residual value guarantee for purposes of assessing whether the lease meets the criterion in paragraph 842-10-25-3(b)(1) to be classified as a direct financing lease is the rate implicit in the lease of 4.646 percent, which includes the initial direct costs of $2,000 that Lessor incurred.

55-33 At the commencement date, Lessor derecognizes the equipment and recognizes a net investment in the lease of $56,000, which is equal to the carrying amount of the underlying asset of $54,000 plus the initial direct costs of $2,000 that are included in the measurement of the net investment in the lease in accordance with paragraph 842-30-25-8 (that is, because the lease is classified as a direct financing lease). The net investment in the lease includes a lease receivable of $58,669 (the present value of the 6 annual lease payments of $9,500 and the third-party residual value guarantee of $13,000, discounted at the rate implicit in the lease of 4.646 percent), an unguaranteed residual asset of $5,331 (the present value of the difference between the estimated residual value of $20,000 and the third-party residual value guarantee of $13,000, discounted at 4.646 percent), and deferred selling profit of $8,000.

55-34 Lessor calculates the deferred selling profit of $8,000 in this Example as follows:

The lease receivable ($58,669); minus
The carrying amount of the equipment ($54,000), net of the unguaranteed residual asset ($5,331), which equals $48,669; minus
The initial direct costs included in the measurement of the net investment in the lease ($2,000).

55-35 At the end of Year 1, Lessor recognizes the receipt of the lease payment of $9,500 and interest on the net investment in the lease of $4,624 (the beginning balance of the net investment in the lease of $56,000 × the discount rate that, at the commencement date, would have resulted in the sum of the lease receivable and the unguaranteed residual asset equaling $56,000, which is 8.258 percent), resulting in a balance in the net investment of the lease of $51,124.

55-36 Also at the end of Year 1, Lessor calculates, for disclosure purposes, the separate components of the net investment in the lease: the lease receivable, the unguaranteed residual asset, and the deferred selling profit. The lease receivable equals $51,895 (the beginning balance of the lease receivable of $58,669 – the annual lease payment received of $9,500 + the amount of interest income on the lease receivable during Year 1 of $2,726, which is $58,669 × 4.646%). The unguaranteed residual asset equals $5,578 (the beginning balance of the unguaranteed residual asset of $5,331 + the interest income on the unguaranteed residual asset during Year 1 of $247, which is $5,331 × 4.646%). The deferred selling profit equals $6,349 (the initial deferred selling profit of $8,000 – $1,651 recognized during Year 1 [the $1,651 is the difference between the interest income recognized on the net investment in the lease during Year 1 of $4,624 calculated in paragraph 842-30-55-35 and the sum of the interest income earned on the lease receivable and the unguaranteed residual asset during Year 1]).

55-37 At the end of Year 2, Lessor recognizes the receipt of the lease payment of $9,500 and interest on the net investment in the lease (the beginning of Year 2 balance of the net investment in the lease of $51,124 × 8.258%, which is $4,222), resulting in a carrying amount of the net investment in the lease of $45,846.

55-38 Also at the end of Year 2, Lessor calculates the separate components of the net investment in the lease. The lease receivable equals $44,806 (the beginning of Year 2 balance of $51,895 – the annual lease payment received of $9,500 + the interest income earned on the lease receivable during Year 2 of $2,411, which is $51,895 × 4.646%). The unguaranteed residual asset equals $5,837 (the beginning of Year 2 balance of the unguaranteed residual asset of $5,578 + the interest income earned on the unguaranteed residual asset during Year 2 of $259, which is $5,578 × 4.646%). The deferred selling profit equals $4,797 (the beginning of Year 2 balance of deferred selling profit of $6,349 – $1,552 recognized during Year 2 [the $1,552 is the difference between the interest income recognized on the net investment in the lease during Year 2 of $4,222 and the sum of the interest income earned on the lease receivable and the unguaranteed residual asset during Year 2]).

55-39 At the end of Year 6, Lessor reclassifies the net investment in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment.

Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record.

Step 1: Gather the Facts

Lease term: 6 years.
Lease payments: $9,500/year beginning at the end of year 1.
Residual value guarantee provided by a third party: $13,000.
Collection of the lease payments and residual value guarantee as of commencement is probable.
Economic life of equipment: 9 years.
Carrying amount: $54,000.
Fair value: $62,000.
Expected residual value at end of term: $20,000.
No transfer of ownership and no purchase options.
Lessor incurred $2,000 in initial direct costs.

Step 2: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate in such a way that the sum equals the fair value of the asset. Because the lessor must first assess sales-type lease classification and the fair value of the underlying asset differs from its carrying amount, the lessor initially does not include the initial direct costs in its calculation of the rate implicit in the lease.

Step 3: Determine the Lease Classification

The lessor would apply the criteria in ASC 842-10-25-2 to determine whether the lease should be classified as a sales-type lease:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. The remaining economic life of the equipment is nine years, and the lease term is six years. Management concludes that this does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $47,482. As it is required to do in performing the sales-type lease classification test, a lessor must include the present value of the entire residual value guarantee provided by the lessee. Because no residual value guarantees were provided by the lessee, the total present value is $47,482. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($62,000).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because none of the above criteria are met, the lease is not a sales-type lease. The lessor would then use the criteria in ASC 842-10-25-3 to determine whether the lease is a direct financing lease:

ASC 842-10-25-3(b)(1) — Does the present value of the sum of the lease payments and a residual value guaranteed by a third party equal or exceed substantially all of the fair value of the underlying asset?

Yes. The present value of the sum of the lease payments is $48,770, and the lessee has not provided any residual value guarantees that are not already reflected in the lease payments. The residual value guarantee provided by the third party is $13,000, and its present value is $9,899. The sum of $48,770 and $9,899 is $58,669.

Management concludes that the lease payments and the residual value guarantee provided by the third party constitute substantially all of the fair value of the asset ($62,000).

Note that the discount rate used to determine the present value of the lease payments and the residual values is 4.646 percent because, when determining whether the lease is a direct financing lease, the lessor includes initial direct costs in its determination of the rate implicit in the lease.

ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?

Yes.

Because both of these criteria are met, the lease is a direct financing lease.

Step 4: Record the Commencement-Date Journal Entries

At lease commencement, the lessor must derecognize the asset and record the net investment in the lease. The discount rate to be applied should cause the unguaranteed residual asset and lease payments (which include the guaranteed residual asset) to equal the fair value of the asset plus any initial direct costs. In calculating the net investment in the lease, the lessor determines that the present value of the lease payments not yet received is $48,770. The present value of the unguaranteed and guaranteed residual assets the lessor expects to receive is $15,230. The fair value of the underlying asset ($62,000) is $8,000 greater than the carrying value ($54,000); therefore, the net investment in the lease should be reduced by $8,000, since no selling profit is immediately recognizable for a direct financing lease. The basis in the net investment in the lease includes the initial direct costs paid. In other words, in the calculation of the implicit rate in the lease, the outflow payment includes the $2,000 in initial direct costs.

Using the amounts calculated above, the lessor would record the following journal entry at lease commencement:

Step 5: Record the Activities Related to the Direct Financing Lease

In year 1, the lessee must pay the lessor $9,500. The payment is related to the accretion on the residual asset, the recognition of a portion of the deferred profit, interest income, and a payment toward the receivable balance. The interest is the net investment in the lease multiplied by the rate, 8.258 percent, that would have caused the sum of the lease receivable and the unguaranteed residual asset to equal $56,000.

The cash payments should be recorded as follows through year 6:

Step 6: Record the Return of the Underlying Asset to the Lessor

The ending net investment in the lease represents the expected value of the underlying asset when it is returned by the lessee. The entry to reflect the return of the underlying asset is depicted below.

9.3.8.2 Impairment

When it is not probable that the lease payments will be collected at commencement, it is not possible to classify a lease as a direct financing lease and, provided that the lease is not a sales-type lease, it will be considered an operating lease (see Section 9.2.2.1). In other words, the underlying asset would not be derecognized and would be subject to an impairment analysis under ASC 360.

Other impairment considerations related to direct financing leases are similar to those for sales-type leases. See Section 9.3.7.5 for more information.

9.3.8.3 Sale of Lease Receivable

The guidance on sales of lease receivables for direct financing leases is the same as that for sales-type leases. See Section 9.3.7.6 for further details.

9.3.8.4 Lease Modification

The example below from the implementation guidance in ASC 842-10-55-201 through 55-203 illustrates the modification of a direct financing lease and applies to Cases A–C, which are discussed in the sections below.

ASC 842-10

Example 22 — Modification of a Direct Financing Lease

55-201 Lessor enters into a six-year lease of a piece of new, nonspecialized equipment with a nine-year economic life. The annual lease payments are $11,000, payable in arrears. The estimated residual value of the equipment is $21,000, of which $15,000 is guaranteed by a third-party unrelated to Lessee or Lessor. The lease does not contain an option for Lessee to purchase the equipment, and the title does not transfer to Lessee as a consequence of the lease. The fair value of the equipment at lease commencement is $65,240, which is equal to its cost (and carrying amount). Lessor incurs no initial direct costs in connection with the lease. The rate implicit in the lease is 7.5 percent such that the present value of the lease payments is $51,632 and does not amount to substantially all of the fair value of the equipment.

55-202 The Lessor concludes that the lease is not a sales-type lease because none of the criteria in paragraph 842-10-25-2 are met. However, the sum of the present value of the lease payments and the present value of the residual value of the underlying asset guaranteed by the third-party guarantor is $61,352, which is substantially all of the fair value of the equipment, and collectibility of the lease payments is probable. Consequently, the lease is classified as a direct financing lease. Lessor recognizes the net investment in the lease of $65,240 (which includes the lease receivable of $61,352 and the present value of the unguaranteed residual value of $3,888 [the present value of the difference between the expected residual value of $21,000 and the guaranteed residual value of $15,000]) and derecognizes the equipment with a carrying amount of $65,240.

55-203 At the end of Year 1, Lessor receives a lease payment of $11,000 from Lessee and recognizes interest income of $4,893 ($65,240 × 7.5%). Therefore, the carrying amount of the net investment in the lease is $59,133 ($65,240 + $4,893 – $11,000).

9.3.8.4.1 Modified Lease Is a Sales-Type Lease

ASC 842-10

25-16 If a direct financing lease is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8, the lessor shall account for the modified lease as follows: . . .

b. If the modified lease is classified as a sales-type lease, the lessor shall account for the modified lease in accordance with the guidance applicable to sales-type leases in Subtopic 842-30, with the commencement date of the modified lease being the effective date of the modification. In calculating the selling profit or selling loss on the lease, the fair value of the underlying asset is its fair value at the effective date of the modification and its carrying amount is the carrying amount of the net investment in the original lease immediately before the effective date of the modification. . . .

Upon concluding that a lease modification has occurred and that the modification is not accounted for as a separate contract (see Section 9.3.4), the lessor should apply the guidance applicable to a sales-type lease if the terms and conditions and facts and circumstances present as of the modification effective date indicate the lease is a sales-type lease. The commencement date of the sales-type lease is the effective date of the modification. The selling profit recognized is the difference between the fair value as of the modification date and the carrying value of the net investment in the original lease immediately before the effective date of the modification.

The scenario below, reprinted from Example 22 in ASC 842-10-55, illustrates the modification from a direct financing lease to a sales-type lease.

ASC 842-10

Case B — Direct Financing Lease to Sales-Type Lease

55-206 At the end of Year 1, the lease term is extended for two years. The lease payments remain $11,000 annually, paid in arrears, for the remainder of the lease term. The estimated residual value is $6,500, of which none is guaranteed. The rate implicit in the modified lease is 7.58 percent. At the effective date of the modification, the remaining economic life of the equipment is 8 years, and the fair value of the equipment is $62,000. Because the modified lease term is now for the major part of the remaining economic life of the equipment, the modified lease is classified as a sales-type lease.

55-207 On the effective date of the modification, Lessor recognizes a net investment in the sales-type lease of $62,000, which is equal to the fair value of the equipment at the effective date of the modification, and derecognizes the carrying amount of the net investment in the original direct financing lease of $59,133. The difference of $2,867 is the selling profit on the modified lease. After the effective date of the modification, Lessor accounts for the sales-type lease in the same manner as any other sales-type lease in accordance with Subtopic 842-30.

Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record. To account for the original lease before modification, see steps 1–5. To account for the lease after modification, see steps 6–9.

Step 1: Gather the Facts

Lease term: 6 years.
Lease payments: $11,000/year beginning at the end of year 1.
Residual value guarantee provided by third party: $15,000.
Collection of the lease payments and residual value guarantee as of commencement is probable.
Remaining economic life of equipment: 9 years.
Carrying amount: $65,240.
Fair value: $65,240.
Expected residual value at end of term: $21,000.
No transfer of ownership and no purchase options; the economic-life criterion is not met.
Lessor incurred no initial direct costs.

Step 2: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate in such a way that the sum equals the fair value of the asset.

Step 3: Determine the Lease Classification

The lessor would apply the criteria in ASC 842-10-25-2 to determine whether the lease should be classified as a sales-type lease:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. Management concludes that the lease term does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $51,632. As it is required to do in performing the sales-type lease classification test, a lessor must only include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($65,240).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because none of the above criteria are met, the lease is not a sales-type lease. The lessor would then apply the criteria in ASC 842-10-25-3 to determine whether the lease is a direct financing lease:

Yes. The present value of the sum of the lease payments is $51,632; the lessee has not provided any residual value guarantees that are not already reflected in the lease payments. The residual value guarantee provided by the third party is $15,000, and its present value is $9,719. The sum of $51,632 and $9,719 is $61,351.

Management concludes that the lease payments and the residual value guarantee provided by the third party constitute substantially all of the fair value of the asset ($65,240).

ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?

Yes.

Because both of these criteria are met, the lease is a direct financing lease.

Step 4: Record the Commencement-Date Journal Entries

At lease commencement, the lessor must derecognize the asset and record the net investment in the lease. The discount rate to be applied should cause the unguaranteed residual asset and lease payments (which include the guaranteed residual asset) to equal the fair value of the asset plus any initial direct costs. In calculating the net investment in the lease, the lessor identifies the present value of the lease payments not yet received as $51,632. The present value of the unguaranteed and guaranteed residual assets the lessor expects to receive is $13,608. The fair value of the underlying asset ($65,240) is equal to the carrying value ($65,240); therefore, the net investment in the lease does not need to be reduced by any amount since there is no implied selling profit to be deferred. The basis in the net investment in the lease should include the initial direct costs paid, but no amounts were paid in this example.

Using the amounts calculated above, the lessor would record the following journal entry at lease commencement:

Step 5: Record the Premodification Activities Related to the Direct Financing Lease

In year 1, the lessee must pay the lessor $11,000. The payment is related to the accretion on the residual asset, interest income, and a payment toward the receivable balance. The interest is the net investment in the lease multiplied by the rate (7.5 percent) that would cause the sum of the lease receivable and the unguaranteed residual asset to equal $65,240. The following journal entry would be recorded:

This results in a $59,133 balance in the net investment in the lease at the end of year 1.

Step 6: Gather the Facts Related to the Modification

Lease term is extended for 2 years (total remaining lease term after modification is 7 years).
Lease payments are the same, $11,000/year.
Estimated residual value is $6,500, no guarantees provided.
Remaining economic life of the equipment is 8 years.
Fair value of the equipment is $62,000.

Step 7: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate so that the sum equals the fair value of the asset.

Step 8: Determine the Lease Classification

The lessor reevaluates the lease in accordance with the criteria in ASC 842-10-25-2:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	Yes. Management concludes that the lease term constitutes a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	Not assessed because the criterion in ASC 842-10- 25-2(c) is already met.
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because the criterion in ASC 842-10-25-2(c) is now met, the lease is a sales-type lease.

Step 9: Record Journal Entries Related to the Modification

As of the effective date of the modification, the lessor must derecognize the existing net investment in the lease of $59,133. The selling profit will be recognized immediately and represents the difference between the fair value of the underlying asset and the carrying value of the net investment in the lease immediately before the modification. The following journal entry would be recorded:

9.3.8.4.2 Modified Lease Is a Direct Financing Lease

ASC 842-10

If the modified lease is classified as a direct financing lease, the lessor shall adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease immediately before the effective date of the modification. . . .

The scenario below, reprinted from Example 22 in ASC 842-10-55 (see the facts that apply to this scenario in Section 9.3.8.4), illustrates the modification of a direct financing lease to another direct financing lease.

ASC 842-10

Case A — Direct Financing Lease to Direct Financing Lease

55-204 At the end of Year 1, the lease term is reduced by 1 year and the annual lease payment is reduced to $10,000 for the remaining 4 years of the modified lease term. The estimated residual value of the equipment at the end of the modified lease term is $33,000, of which $30,000 is guaranteed by the unrelated third party, while the fair value of the equipment is $56,000. The remaining economic life of the equipment is 8 years, and the present value of the remaining lease payments, discounted using the rate implicit in the modified lease of 8.857 percent, is $32,499. Lessor concludes that the modified lease is not a sales-type lease because none of the criteria in paragraph 842-10-25-2 are met. However, the sum of the present value of the lease payments and the present value of the residual value of the underlying asset guaranteed by the third-party guarantor, discounted using the rate implicit in the modified lease of 8.857 percent, is $53,864, which is substantially all of the fair value of the equipment, and collectibility of the lease payments is probable. As such, the modified lease is classified as a direct financing lease.

55-205 In accounting for the modification in accordance with paragraph 842-10-25-16(a), Lessor carries forward the balance of the net investment in the lease of $59,133 immediately before the effective date of the modification as the opening balance of the net investment in the modified lease. To retain the same net investment in the lease even while the lease payments, the lease term, and the estimated residual value have all changed, Lessor adjusts the discount rate for the lease from the rate implicit in the modified lease of 8.857 percent to 6.95 percent. This discount rate is used to calculate interest income on the net investment in the lease throughout the remaining term of the modified lease and will result, at the end of the modified lease term, in a net investment balance that equals the estimated residual value of the underlying asset of $33,000.

Step 1: Gather the Facts

Lease term: 6 years.
Lease payments: $11,000/year beginning at the end of year 1.
Residual value guarantee provided by third party: $15,000.
Collection of the lease payments and residual value guarantee as of commencement is probable.
Carrying amount: $65,240.
Remaining economic life of equipment: 9 years.
Fair value: $65,240.
Expected residual value at end of term: $21,000.
No transfer of ownership and no purchase options; the economic-life criterion is not met.
Lessor incurred no initial direct costs.

Step 2: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate so that the sum equals the fair value of the asset.

Step 3: Determine the Lease Classification

The lessor would apply the criteria in ASC 842-10-25-2 to determine whether the lease should be classified as a sales-type lease:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. Management concludes that the lease term does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $51,632. As it is required to do in performing the sales-type lease classification test, a lessor must only include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($65,240).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Yes. The present value of the sum of the lease payments is $51,632 (as shown above), and the lessee does not provide any residual value guarantees that are not already reflected in the lease payments. The residual value guarantee provided by the third party is $15,000, and its present value is $9,719. The sum of $51,632 and $9,719 is $61,351.

Management concludes that the lease payments and the residual value guarantee provided by the third party constitute substantially all of the fair value of the asset ($65,240).

ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?

Yes.

Because both of these criteria are met, the lease is a direct financing lease.

Step 4: Record the Commencement-Date Journal Entries

At lease commencement, the lessor must derecognize the asset and record the net investment in the lease. The discount rate to be applied should cause the unguaranteed residual asset and lease payments (which include the guaranteed residual asset) to equal the fair value of the asset plus any initial direct costs. To calculate the net investment in the lease, the lessor identifies the present value of the lease payments not yet received as $51,632. The present value of the unguaranteed and guaranteed residual assets the lessor expects to receive is $13,608. The fair value of the underlying asset ($65,240) is equal to the carrying value ($65,240) and the net investment in the lease therefore does not need to be reduced by any amount since there is no implied selling profit to be deferred. The basis in the net investment in the lease should include the initial direct costs paid, but no amounts were paid in this example.

Using the amounts calculated above, the lessor would record the following journal entry at lease commencement:

Step 5: Record the Premodification Activities Related to the Direct Financing Lease

In year 1, the lessee must pay the lessor $11,000. The payment is related to the accretion on the residual asset, interest income, and a payment toward the receivable balance. The interest is the net investment in the lease multiplied by the rate (7.5 percent) that would have caused the sum of the lease receivable and the unguaranteed residual asset to equal $65,240. The following journal entry would be recorded:

This results in a balance in the net investment in the lease of $59,133 at the end of year 1.

Step 6: Gather the Facts Related to the Modification

Lease term is reduced by 1 year.
Remaining lease payments are reduced to $10,000/year.
Estimated residual value is $33,000, of which $30,000 is guaranteed by an unrelated third party.
Fair value of the equipment is $56,000.
Remaining economic life of the equipment is 8 years.

Step 7: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate in such a way that the sum equals the fair value of the asset.

Step 8: Determine the Lease Classification

The lessor reevaluates the lease in accordance with the criteria in ASC 842-10-25-2:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. Management concludes that the lease term does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $32,499. As it is required to do in performing the sales-type lease classification test, a lessor must only include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($56,000).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because none of the above criteria are met, the lease is not a sales-type lease. The lessor then applies the criteria in ASC 842-10-25-3 to determine whether the lease is a direct financing lease:

Yes. The present value of the sum of the lease payments is $32,499, and the lessee has not provided any residual value guarantees that are not already reflected in the lease payments. The residual value guarantee provided by the third party is $30,000, and its present value is $21,365.

The sum of $32,499 and $21,365 is $53,864. Management concludes that the lease payments and the residual value guarantee provided by the third party constitute substantially all of the fair value of the asset ($56,000).

ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?

Yes.

Because both of these criteria are met, the lease is a direct financing lease.

Step 9: Record Journal Entries Related to the Modification

As of the effective date of the modification, the lessor should adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease immediately before the effective date. Therefore, the lessor will carry forward the balance of the net investment in the lease immediately before the modification, which is $59,133. The discount rate will change from 8.857 percent to 6.95 percent. The discount rate is used to calculate interest income on the net investment in the lease throughout the remaining term of the modified lease and will result, at the end of the modified term, in a net investment balance of $33,000 that is equal to the estimated residual value of the underlying asset. No journal entries are necessary as of the modification date.

The direct financing lease would be subsequently measured in accordance with the guidance described in Section 9.3.8.

9.3.8.4.3 Modified Lease Is an Operating Lease

ASC 842-10

Upon concluding that a lease modification has occurred and the modification is not accounted for as a separate contract, the lessor should apply the guidance applicable to operating leases if the terms and conditions and facts and circumstances present as of the modification effective date indicate that the lease is an operating lease.

ASC 842-10

Case C — Direct Financing Lease to Operating Lease

55-208 At the end of Year 1, the lease term is reduced by 2 years, and the lease payments are reduced to $9,000 per year for the remaining 3-year lease term. The estimated residual value is revised to $33,000, of which only $13,000 is guaranteed by an unrelated third party. The fair value of the equipment at the effective date of the modification is $56,000. The modified lease does not transfer the title of the equipment to Lessee or grant Lessee an option to purchase the equipment. The modified lease is classified as an operating lease because it does not meet any of the criteria to be classified as a sales-type lease or as a direct financing lease.

55-209 Therefore, at the effective date of the modification, Lessor derecognizes the net investment in the lease, which has a carrying amount of $59,133, and recognizes the equipment at that amount. Collectibility of the lease payments is probable; therefore, Lessor will recognize the $27,000 ($9,000 × 3 years) in lease payments on a straight-line basis over the 3-year modified lease term, as well as depreciation on the rerecognized equipment.

Step 1: Gather the Facts

Lease term: 6 years.
Lease payments: $11,000/year beginning at the end of year 1.
Residual value guarantee provided by third party: $15,000.
Collection of the lease payments and residual value guarantee as of commencement is probable.
Carrying amount: $65,240.
Remaining economic life of equipment: 9 years.
Fair value: $65,240.
Expected residual value at end of term: $21,000.
No transfer of ownership and no purchase options; the economic-life criterion is not met.
Lessor incurred no initial direct costs.

Step 2: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate so that the sum equals the fair value of the asset.

Step 3: Determine the Lease Classification

The lessor would apply the criteria in ASC 842-10-25-2 to determine whether the lease should be classified as a sales-type lease:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. Management concludes that the lease term does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $51,632. As it is required to do in performing the sales-type lease classification test, a lessor must only include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($65,240).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Yes. The present value of the sum of the lease payments is $51,632, and the lessee does not provide any residual value guarantees that are not already reflected in the lease payments. The residual value guarantee provided by the third party is $15,000, and its present value is $9,719. The sum of $51,632 and $9,719 is $61,351.

Management concludes that the lease payments and the residual value guarantee provided by the third party constitute substantially all of the fair value of the asset ($65,240).

ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?

Yes.

Because both of these criteria are met, the lease is a direct financing lease.

Step 4: Record the Commencement-Date Journal Entries

At lease commencement, the lessor must derecognize the asset and record the net investment in the lease. The discount rate to be applied should cause the unguaranteed residual asset and lease payments (which include the guaranteed residual asset) to equal the fair value of the asset plus any initial direct costs. To calculate the net investment in the lease, the lessor identifies the present value of the lease payments not yet received as $51,632. The present value of the unguaranteed and guaranteed residual asset the lessor expects to receive is $13,608. The fair value of the underlying asset ($65,240) is equal to the carrying value ($65,240), and the net investment in the lease therefore does not need to be reduced by any amount since there is no implied selling profit to be deferred. The basis in the net investment in the lease should include the initial direct costs paid, but no amounts were paid in this example.

Using the amounts calculated above, the lessor would record the following journal entry at lease commencement:

Step 5: Record the Premodification Activities Related to the Direct Financing Lease

In year 1, the lessee must pay the lessor $11,000. The payment is related to the accretion on the residual asset, interest income, and a payment toward the receivable balance. The interest is the net investment in the lease multiplied by the rate (7.5 percent) that would have caused the sum of the lease receivable and the unguaranteed residual asset to equal $65,240. The following journal entry would be recorded:

This results in a balance in the net investment in the lease of $59,133 at the end of year 1.

Step 6: Gather the Facts Related to the Modification

At the end of year 1:

The lease term is reduced by 2 years.
Lease payments are reduced to $9,000/year for the remaining 3 years.
The estimated residual value is $33,000, of which $13,000 is guaranteed by an unrelated third party.
The fair value of the equipment is $56,000.

Step 7: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate in such a way that the sum equals the fair value of the asset.

Step 8: Determine the Lease Classification

The lessor reevaluates the lease in accordance with the criteria in ASC 842-10-25-2:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. Management concludes that the lease term does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $25,580. In a manner consistent with the requirements related to performing the sales-type lease classification test, a lessor must only include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($56,000).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because none of the above criteria are met, the lease is not a sales-type lease. The lessor then applies the criteria in ASC 842-10-25-3 to determine whether the lease is a direct financing lease:

No. The present value of the sum of the lease payments is $25,580, and the lessee does not provide any residual value guarantees that are not already reflected in the lease payments. The residual value guarantee provided by the third party is $13,000, and its present value is $11,984. The sum of $25,580 and $11,984 is $37,564.

Management concludes that the lease payments and the residual value guarantee provided by the third party do not constitute substantially all of the fair value of the asset ($56,000).

ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?

Yes.

Because the lease does not meet both of these criteria, the lease is not a direct financing lease but is an operating lease.

Step 9: Record Journal Entries Related to the Modification

As of the effective date of the modification, the lessor should derecognize the net investment in the lease and recognize the carrying value of the equipment at the basis in the net investment in the lease. The following journal entry would be recorded:

The operating lease would be subsequently accounted for in accordance with the guidance in Section 9.3.9.1; similarly, the asset would be subject to depreciation and impairment under ASC 360.

9.3.8.5 Lease Termination

ASC 842-30

40-2 If a . . . direct financing lease is terminated before the end of the lease term, a lessor shall do all of the following:

Measure the net investment in the lease for credit losses in accordance with Subtopic 326-20 on financial instruments measured at amortized cost and record any credit loss identified
Reclassify the net investment in the lease to the appropriate category of asset in accordance with other Topics, measured at the sum of the carrying amounts of the lease receivable (less any amounts still expected to be received by the lessor) and the residual asset
Account for the underlying asset that was the subject of the lease in accordance with other Topics.

40-4 For guidance on the acquisition of the residual value of an underlying asset by a third party, see paragraph 360-10-25-2.

If a direct financing lease is terminated before the end of the lease term, the net investment in the lease must be tested for impairment in the manner described above and any impairment loss must be recognized. The underlying asset must then be appropriately reclassified and subsequently accounted for in accordance with ASC 360.

9.3.8.6 End of Lease Term

The guidance on the end of the lease term is the same for direct financing leases as it is for sales-type leases. See Section 9.3.7.9 for more information.

9.3.9 Operating Lease

With operating leases, the underlying asset remains on the lessor’s balance sheet and is depreciated consistently with other owned assets. Income from an operating lease is recognized on a straight-line basis unless another systematic and rational basis is more appropriate. Any initial direct costs (i.e., those that are incremental to the arrangement and that would not have been incurred if the lease had not been obtained) are deferred and expensed over the lease term in a manner consistent with the way lease income is recognized.

9.3.9.1 Recognition, Initial Measurement, and Subsequent Measurement

ASC 842-30

25-10 At the commencement date, a lessor shall defer initial direct costs.

25-11 After the commencement date, a lessor shall recognize all of the following:

The lease payments as income in profit or loss 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, subject to paragraph 842-30-25-12
Variable lease payments 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
Initial direct costs as an expense over the lease term on the same basis as lease income (as described in (a)).

55-17 This Subtopic considers the right to control the use of the underlying asset as the equivalent of physical use. If the lessee controls the use of the underlying asset, recognition of lease income in accordance with paragraph 842-30-25-11(a) should not be affected by the extent to which the lessee uses the underlying asset.

As noted above, for operating leases, lessors must recognize “income in profit or loss 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.”

Example 9-14

Assume that Company A leases a building to Company B for a 10-year period under an operating lease. The first-year lease payment is $1 million, which increases by $100,000 per year for each subsequent year. Assume that all amounts are allocable to the lease component. Collection of the lease payments is probable.

Company A should recognize lease revenue of $1.45 million per year (total receipts of $14.5 million ÷ 10 years). In years 1–5, A should record the difference between the rental income and rent collected each year as an asset. In years 6–10, the rent payments collected in excess of the rental income recognized each year should be credited to the asset.

The journal entry to record the initial lease payment would be as follows:

Connecting the Dots

Recognizing Rental Revenues on an Other Than Straight-Line Basis

Upon the issuance of ASC 842, many believed that lessors should consider the recognition pattern for uneven rents in an operating lease and potentially recognize revenue on an other than straight-line basis if the uneven rents were designed to reflect market conditions. That view was based principally on the language in paragraph BC327 of ASU 2016-02, which states, in part, that “a lessor is expected to recognize uneven fixed lease payments on a straight-line basis when the payments are uneven for reasons other than to reflect or compensate for market rentals or market conditions” (emphasis added). However, on the basis of discussions with the FASB staff, we understand that paragraph BC327 was not intended to require or permit a lessor to deviate from straight-line recognition, even when uneven rents are designed to reflect market conditions. Accordingly, in a manner similar to their accounting under ASC 840, lessors will continue to recognize rental income from operating leases 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.

Lessor’s Sale or Assignment of Operating Lease Payments

A lessor may enter into a transaction to sell or assign lease payments due under an operating lease. The lessor’s sale or assignment of lease payments due under an operating lease should be accounted for as a borrowing because a lessor’s economic interest in an operating lease is not a receivable but a right to future revenues under an executory contract. The presumption is that lessors have an obligation to provide services to earn the lease revenues, even when such an obligation involves minimal effort. Therefore, proceeds from such a sale or assignment should be accounted for as a borrowing.

Curtailment of the Lessee’s Right to Use the Underlying Asset

In certain situations, the lessee’s ability to derive its intended economic benefits from the use of a leased asset may be significantly curtailed. For example, during natural disasters or periods of civil unrest, a lessee leasing retail space may be forced not to sell goods from the leased space for an extended period. In such circumstances, as long as the lessee retains its right to use the underlying asset, the lessor would still be fulfilling its obligation under the lease and should not suspend its revenue recognition during the curtailment period on the basis of an estimate of a reduction in the asset’s utility or in the economic benefits that the lessee derives from use of the asset. However, in assessing the accounting implications of such situations, an entity must perform a holistic analysis that takes into account, among other factors, the impact of any (1) resulting changes to the terms and conditions of the original contract (see Section 9.3.4 for guidance on lease modifications) and (2) rent concessions offered or negotiated (see the Connecting the Dots in Section 9.3.4).

9.3.9.2 Collectibility

ASC 842-30

25-12 If collectibility of the lease payments plus any amount necessary to satisfy a residual value guarantee (provided by the lessee or any other unrelated third party) is not probable at the commencement date, lease income shall be limited to the lesser of the income that would be recognized in accordance with paragraph 842-30-25-11(a) through (b) or the lease payments, including variable lease payments, that have been collected from the lessee.

25-13 If the assessment of collectibility changes after the commencement date, any difference between the lease income that would have been recognized in accordance with paragraph 842-30-25-11(a) through (b) and the lease payments, including variable lease payments, that have been collected from the lessee shall be recognized as a current-period adjustment to lease income.

25-14 See Example 1 (paragraphs 842-30-55-18 through 55-43) for an illustration of the requirements when collectibility is not probable.

The scenario below, reprinted from Example 1, Case D, in ASC 842-30-55, illustrates the lessor’s accounting for an operating lease when collectibility is not probable.

ASC 842-30

Example 1 — Lessor Accounting Example

Case D — Lessor Accounting — Collectibility Is Not Probable

55-40 Assume the same facts and circumstances as Case C (paragraphs 842-30-55-31 through 55-39), except that collectibility of the lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party is not probable and the lease payments escalate every year over the lease term. Specifically, the lease payment due at the end of Year 1 is $7,000, and subsequent payments increase by $1,000 every year for the remainder of the lease term. Because it is not probable that Lessor will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party in accordance with paragraph 842-10-25-3, Lessor classifies the lease as an operating lease.

55-41 Lessor continues to measure the equipment in accordance with Topic 360 on property, plant, and equipment.

55-42 Because collectibility of the lease payments is not probable, Lessor recognizes lease income only when Lessee makes the lease payments, and in the amount of those lease payments. Therefore, Lessor only recognizes lease income of $7,000 at the point in time Lessee makes the end of Year 1 payment for that amount.

55-43 At the end of Year 2, Lessor concludes that collectibility of the remaining lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party is probable; therefore, Lessor recognizes lease income of $12,000. The amount of $12,000 is the difference between lease income that would have been recognized through the end of Year 2 ($57,000 in total lease payments ÷ 6 years = $9,500 per year × 2 years = $19,000) and the $7,000 in lease income previously recognized. Collectibility of the remaining lease payments remains probable throughout the remainder of the lease term; therefore, Lessor continues to recognize lease income of $9,500 each year.

The lessor in the above scenario would perform the following steps and record the following journal entries:

Step 1: Gather the Facts

Lease term: 6 years.
Lease payments: $7,000 at end of year 1, increasing by $1,000 every year for the remainder of the term.
Residual value guarantee provided by a third party: $13,000.
Collection of the lease payments and residual value guarantee as of commencement is not probable.
Economic life of equipment: 9 years.
Carrying amount: $54,000.
Fair value: $62,000.
Expected residual value at end of term: $20,000.
No transfer of ownership and no purchase options.
Lessor incurred $2,000 in initial direct costs.

Step 2: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate in such a way that the sum equals the fair value of the asset.

Step 3: Determine the Lease Classification

The lessor would apply the criteria in ASC 842-10-25-2 to determine whether the lease should be classified as a sales-type lease:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. The remaining economic life of the equipment is nine years and the lease term is six years. Management concludes that this does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $47,219. As it is required to do in performing the sales-type lease classification test, the lessor must include the present value of the entire residual value guarantee provided by the lessee. Because the lessee did not provide any residual value guarantees, the total present value is $47,219. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($62,000).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because none of the above criteria are met, the lease is not a sales-type lease. The lessor would then evaluate the criteria in ASC 842-10-25-3(b) to determine whether the lease is a direct financing lease:

Yes. The present value of the sum of the lease payments is $48,538, and the lessee has not provided any residual value guarantees that are not already reflected in the lease payments. The residual value guarantee provided by the third party is $13,000 and its present value is $10,050. The sum of $48,538 and $10,050 is $58,588.

Management concludes that the lease payments and the residual value guarantee provided by a third party constitute substantially all of the fair value of the asset ($62,000).

Note that the discount rate used to determine the present value of the lease payments and the residual values is 4.383 percent because, when determining whether the lease is a direct financing lease, the lessor includes initial direct costs in its determination of the rate implicit in the lease.

ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?

No.

Because collectibility is not probable, the lease is not a direct financing lease and is an operating lease.

Step 4: Commencement-Date Entries

Because no assets are derecognized, there are no entries on the commencement date.

Step 5: Year 1 Entry

Because collectibility is not probable, the lessor recognizes lease income only when the lessee makes the lease payment and in the amount of those lease payments.

Step 6: Year 2 Entry

At the end of year 2, the lessor concludes that collectibility of the remaining lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party is probable; therefore, the lessor recognizes income of $12,000. The calculation is as follows:

$57,000 in total lease payments ÷ 6 years = $9,500 per year; $9,500 × 2 = $19,000; recognized to date = $7,000.
$19,000 – $7,000 = $12,000, recognized in year 2.

Importantly, the lessor is not required or permitted to reassess classification as a result of the change in the collectibility assessment (i.e., for a direct financing lease to exist, collectibility must be probable at commencement).

Step 7: Entries During the Remaining Lease Term

Because collectibility of the payments is probable throughout the remaining lease term, the lessor continues to recognize $9,500 each year.

The lessor in the above scenario would have recorded the following lease income (revenue) and straight-line operating lease receivable over the life of the lease:

On the basis of the above guidance, the operating lease collectibility model in ASC 842-30 indicates that a lessor must assess whether the collectibility of future operating lease payments is probable. Under the ASC 842-30 collectibility model, an entity continually evaluates whether it is probable that future operating lease payments will be collected. This collection assessment is based on the individual lessee’s credit risk, as opposed to potential disputed charges. When collectibility of lease payments17 is probable, the lessor will apply an accrual model; for example, it will recognize a straight-line lease receivable to ensure ratable recognition of revenue over the lease term. See Example 9-14, which illustrates this concept. When collectibility is not probable, the lessor will limit lease income to cash received, as described above in ASC 842-30-25-13.

Connecting the Dots

Collectibility Assessment of Disputed Charges

Questions have been raised regarding “disputed” charges and whether or in what circumstances disputed amounts should be assessed for whether it is probable that the lease payments will be collected. We believe that it would be appropriate for a lessor to evaluate the “enforceable” lease payments first before assessing collectibility; this evaluation should be performed in a manner consistent with ASC 606.18 That is, the lessor first evaluates its invoiced amounts to determine whether certain payments may be subject to dispute with its customer (tenant). In circumstances in which it is known or expected that all, or some portion, of an invoiced amount will be subject to a future reduction in the amount expected to be collected for the right to use the lessor’s asset, the lessor should consider any adjustment for these items in a manner similar to the accounting for a price concession within the scope of the revenue standard (see Section 4.3.5 of Deloitte’s Roadmap Revenue Recognition for further discussion). Therefore, an evaluation of any future reduction in an invoiced amount should be considered before the assessment in ASC 842-30-25-12 regarding the probability of collection.

The lessor would generally not consider disputed amounts (e.g., a lessee that disputes a variable charge for CAM) in its collectibility assessment under ASC 842 since such disputes would not represent “enforceable” rights in the contract. In a manner consistent with ASC 606-10-25-1(e), the lessor would need to evaluate the disputes before it assesses collectibility. The lessor would then evaluate the customer’s intention and ability to pay promised consideration. As a result, in many cases, disputed amounts may not be recognized as a receivable (i.e., there is no enforceable right to cash); this means there is less revenue (lease income) because of the disputed amount.

9.3.9.2.1 Lessor’s Accounting for an Operating Lease When Collectibility Subsequently Becomes Not Probable

If a lessor determines that collectibility is probable at lease commencement but subsequently is no longer probable (i.e., the assessment of probability changes from favorable to unfavorable), the lessor should apply the guidance in ASC 842-30-25-12 and 25-13, as illustrated in Example 1, Case D, above.

Although the illustrative example above demonstrates a lessor’s accounting for an operating lease when collectibility is not probable at lease commencement and subsequently becomes probable, the same principle should be followed in accounting for an operating lease for which the lessor determines that collectibility is probable at lease commencement but subsequently is no longer probable. This is supported by the guidance in ASC 842-30-25-13, which refers to changes in the collectibility assessment after the commencement date. The lessor must apply this guidance regardless of the direction of its change in conclusion about collectibility (i.e., it goes from probable to not probable or not probable to probable).

To demonstrate this accounting, we have used the same facts and circumstances as in Example 1, Case D, except that collectibility of the lease payments19 is probable at lease commencement (assume that the lease is still classified as an operating lease). In year 1, the lessor will recognize straight-line lease income of $9,500 (i.e., $57,000 in total lease payments ÷ 6 years = $9,500 per year) and will record the cash lease payment of $7,000, with the remaining amount recorded as an operating lease receivable of $2,500 (i.e., $9,500 of lease income − $7,000 cash received).

The year 1 journal entry is as follows:

If, at the end of year 2, the lessor concludes that collectibility of the remaining lease payments is not probable, the lessor recognizes lease income of $5,500 (i.e., the difference between the $8,000 of cash lease payments received in year 2 and the $2,500 straight-line receivable balance recorded at the end of year 1). As long as the lessor’s assessment of collectibility remains not probable for the entire lease term, the lessor should record lease income equal to only the amount of cash payments received on a cumulative basis from the lessee.

The lessor in this scenario would have recorded the following lease income and straight-line operating lease receivable over the life of the lease:

9.3.9.2.2 Assessing Impairment of Operating Lease Receivables

In June 2016, the FASB issued ASU 2016-13 (codified as ASC 326), which adds to U.S. GAAP an impairment model — known as the current CECL model — that is based on expected losses rather than incurred losses. The ASU significantly change the accounting for credit impairment.20

In November 2018, the FASB issued ASU 2018-19 to clarify certain aspects of ASU 2016-13, including that operating lease receivables are not within the scope of ASC 326-20. Instead, an entity would need to apply other U.S. GAAP to account for changes in the collectibility assessment for operating leases.

Although ASU 2018-19 amended only ASC 326, which became effective on January 1, 2020, for calendar-year PBEs and January 1, 2023, for calendar-year non-PBEs, we believe that the Board’s clarification that operating lease receivables are within the scope of other guidance, namely ASC 842, rather than ASC 326 may result in a change in how some lessors account for the collectibility of operating lease receivables upon the adoption of ASC 842. We understand that there is currently diversity in practice in how some lessors account for credit losses related to operating lease receivables under ASC 840. Specifically, under current practice, certain lessors account for the collectibility of operating lease receivables in a manner consistent with the way they account for the collectibility of trade receivables (i.e., recognize an allowance for uncollectible accounts and a corresponding bad-debt expense), whereas other lessors account for these credit losses as an adjustment to the related lease income. However, ASC 842 requires all lessors to apply the collectibility guidance discussed above (i.e., no receivable should be recorded when collection of the remaining lease payments is not probable).

9.3.9.2.3 Recognition of a General Allowance for Operating Lease Receivables

Certain lessors recognize a general allowance for credit losses (on a collective or pooled basis) and corresponding bad-debt expense for billed and straight-line operating lease receivables on the basis of the guidance in ASC 450-20 when factors indicate that some or all of the balance is no longer collectible. This guidance was amended by the new CECL impairment model in ASC 326, and most financial assets subject to the guidance in ASC 450-20 are subject to the guidance in ASC 326. In addition, as discussed above, ASC 842 requires lessors to evaluate the collectibility of individual operating leases in accordance with ASC 842-30.

Therefore, questions have arisen about whether an entity can continue to recognize a general allowance for credit losses (on a collective or pooled basis) and corresponding bad-debt expense for operating lease receivables on the basis of the guidance in ASC 450-20.

Two views have emerged regarding whether, after the adoption of ASC 326, a lessor can continue to recognize a general allowance for operating lease receivables for which collectibility is probable. After the adoption of ASC 842, a lessor must apply the guidance in ASC 842-30, as discussed above, for any receivable when collectibility is not probable. That is, any valuation reserve accounting method may be used only after an assessment of whether the collection of future lease payments is deemed probable. Only if the collection of the lease payments over the lease term is deemed probable would the incremental approaches described below be appropriate. If collectibility is not deemed probable, the guidance in ASC 842-30 should be applied and no lease income should be recognized before cash collection.

On the basis of a technical inquiry with the FASB staff, we believe that either of the following approaches is acceptable as an accounting policy choice. A lessor should apply its accounting policy consistently and disclose its election.

View 1: Record an allowance for operating lease receivables — In the Background Information and Basis for Conclusions of ASU 2018-19, the FASB explains that ASC 326-20 was not intended to change historical lessor accounting for operating leases:
BC13. The Board noted that the guidance in Topic 842 provides an operational model for determining the collectibility of lease payments that is well understood by lessors. The Board did not intend to change lessor accounting for operating leases when it issued Update 2016-13. Therefore, the amendments in this Update clarify that receivables resulting from operating leases accounted for by lessors under Topic 842 are not within the scope of Subtopic 326-20. [Emphasis added]

Therefore, although the amendments in ASU 2018-09 clarify that operating lease receivables are outside the scope of ASC 326-20, it continues to be acceptable for a lessor to apply other U.S. GAAP to ensure that receivables for operating leases for which collectibility of lease payments is probable are not overstated when the lessor does not expect to collect 100 percent of its outstanding receivables.

Under this view, in a manner consistent with the current practice described above, a lessor would recognize an allowance for credit losses for operating lease receivables in accordance with ASC 450-20. This would generally be calculated on the total portfolio of operating lease receivables for which collectibility is probable. The example below demonstrates the recording of an allowance for operating lease receivables.

Example 9-15

Lessor X enters into three leases that are each classified as operating leases for which collectibility of future lease payments21 at commencement is probable. For each lease, the term is six years, the lease payment due at the end of year 1 is $7,000, and subsequent payments increase by $1,000 every year for the remainder of the lease term. Lessor X will record the lease payments on a straight-line basis to lease income over the life of the lease and establish a corresponding straight-line operating lease receivable.

Further, X continues to consider whether the operating lease receivables, at a portfolio level, are appropriately valued by using principles that are consistent with those applied under ASC 450-20 (because ASC 326 does not apply) to ensure that its receivables and its income are not overstated. Lessor X has established a policy (on the basis of historical evidence and expectations of future collections) that creates an allowance for 10 percent of all operating lease receivables at the end of each reporting period, recorded as a contra asset. The offset of the 10 percent allowance is recorded to the income statement. (See Section 9.3.9.2.4 for a discussion regarding presentation in the income statement.)

Lessor X would have recorded the following lease income, straight-line operating lease receivable, allowance for the operating lease receivable, and corresponding income statement impact22 over the life of the lease (only the first three years of X’s entries are shown):
View 2: No allowance for operating lease receivables — As stated above, ASU 2018-19 in other places suggests that ASC 842 may be the sole guidance to apply when an entity is considering the impairment of operating lease receivables after the adoption of ASC 326. Under this view, the Codification will no longer provide a basis for evaluating operating lease receivables under ASC 450-20.

Therefore, on the basis of this interpretation of the amendments in ASU 2018-19, a lessor may elect not to record any allowance for operating lease receivables for which collection is deemed probable. Operating lease receivables should be adjusted, and will be taken against lease income, only when a lessor specifically identifies a lease for which collectibility becomes not probable. The lessor will apply the guidance in ASC 842-30-25-12 through 25-14 above to account for changes in collectibility assessments. Under this view, there is no incremental or supplemental general allowance, and no corresponding income statement impact (as illustrated in View 1) would be recorded.

Connecting the Dots

Complexities With General Allowances

Although a lessor can establish an accounting policy of recording an allowance for operating lease receivables for leases for which collectibility is probable (i.e., as in View 1 above), the lessor should understand that maintaining a general allowance in addition to specifically identifying and accounting for leases for which collectibility is not probable may involve more effort than would applying a policy to adjust operating lease receivables only when collectibility is not probable (i.e., as in View 2 above).

However, if the lessor applies only the ASC 842 collectibility guidance (i.e., as in View 2 above) or establishes a general allowance through a reduction of lease income as described in Section 9.3.9.2.4, it will create inconsistency with the accounting for revenue receivables that are within the scope of ASC 606 and therefore within the scope of ASC 326. Given this inconsistent treatment, if a lessor’s leases include nonlease components that are not combined with the lease component under the lessor practical expedient, the lessor will need to apply two separate subsequent-measurement accounting models for contract receivables that contain lease and nonlease (revenue) components.

Additional questions have arisen regarding how an entity that has established an accounting policy of recording an allowance for operating lease receivables through bad-debt expense should account for changes in a collectibility assessment. Specifically, questions have been asked about what accounting is required when a receivable whose collectibility was originally deemed probable and was therefore included in the general allowance subsequently has a collectibility that is not probable (i.e., accounting for the write-off of the operating lease receivable).

We believe that multiple approaches may be acceptable. When determining the appropriate accounting for changes in collectibility, lessors should consider their policies for establishing the general allowance of operating leases for which collectibility is probable and whether, for such an allowance, they contemplated the future write-off of an operating lease receivable within the portfolio of leases. We encourage lessors to consult with their auditors and accounting advisers on this topic.

9.3.9.2.4 Income Statement Classification of General Allowance for Operating Lease Receivables

An entity that establishes an accounting policy of recording a general allowance for operating lease receivables (i.e., as in View 1 in Section 9.3.9.2.3) can record the allowance through either a reduction to lease income (revenue) or through bad-debt expense.

Reduction of lease income — This approach is based on the model established in ASC 842-30 and discussed above. Although the reduction-of-lease-income model in ASC 842-30 is specific to leases for which collectibility is not probable, an entity can apply this same approach and establish an allowance against lease income for expected, but not yet specifically identified, credit issues in the portfolio of leases.
Bad-debt expense — As outlined in View 1 in Section 9.3.9.2.3, in many respects the FASB did not intend to change lessor accounting for operating leases when it issued ASC 326. Under legacy U.S. GAAP, general allowances for operating lease receivables were usually established through bad-debt expense. Therefore, it would be appropriate for an entity to continue using the same approach after the adoption of ASC 842 to be consistent with the FASB’s statement that entities should continue current practice when recording the general allowance.

Connecting the Dots

Disclosure

On the basis of our discussions with the FASB staff, we understand that the SEC staff is aware of the potential diversity that will exist in practice in this area and has noted that entities should ensure that they apply a consistent policy and provide transparent disclosures regarding this policy. Disclosure of such an accounting policy is consistent with the guidance in ASC 842-30-50-1, which states, in part, that “[t]he objective of the disclosure requirements is to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases” (emphasis added).

No Near-Term Changes

ASU 2018-19 clarifies that operating lease receivables are not within the scope of ASC 326. Although stakeholders have expressed opposing views on the appropriateness of this scope clarification, only future standard setting would change the existing accounting. That is, the collectibility of an operating lease receivable is assessed on the basis of the guidance in ASC 842 and not that in ASC 326. Although the FASB is conducting its postimplementation review of the new leasing standard more broadly, this topic is currently not on its technical agenda. However, our views on the inclusion of operating lease receivables within the scope of ASC 326 are expressed in our September 19, 2018, comment letter in response to the FASB's ED that was finalized in ASU 2018-19.

9.3.9.3 Accounting for the Underlying Asset

ASC 842-30

30-4 A lessor shall continue to measure the underlying asset subject to an operating lease in accordance with other Topics.

35-6 A lessor shall continue to measure, including testing for impairment in accordance with Section 360-10-35 on impairment or disposal of long-lived assets, the underlying asset subject to an operating lease in accordance with other Topics.

Because the underlying asset is not derecognized in operating leases, it should be tested for impairment in accordance with ASC 360. The underlying asset should also be subsequently measured under ASC 360 (e.g., depreciation).

9.3.9.4 Sale of Future Operating Lease Payments

If a lessor obtains proceeds from the sale of future operating lease payments that do not meet the definition of a receivable, the sale would be accounted for in a manner similar to a transaction in which proceeds are received from the sale of future revenues under ASC 470, when the seller has significant continuing involvement in the generation of the revenues, and the proceeds from such a sale should be accounted for as debt (see Section 7.2.3.3 of Deloitte’s Roadmap Issuer’s Accounting for Debt for more information).

9.3.9.5 Lease Modification

9.3.9.5.1 Modified Lease Is a Sales-Type Lease

ASC 842-10

25-15 If an operating lease is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8, the lessor shall account for the modification as if it were a termination of the existing lease and the creation of a new lease that commences on the effective date of the modification as follows: . . .

b. If the modified lease is classified as a direct financing lease or a sales-type lease, the lessor shall derecognize any deferred rent liability or accrued rent asset and adjust the selling profit or selling loss accordingly.

As indicated above, when “an operating lease is modified and the modification is not accounted for as a separate contract,” the lessor should apply the guidance applicable to sales-type leases if the terms and conditions and facts and circumstances present as of the modification’s effective date indicate that the lease is a sales-type lease. The commencement date of the sales-type lease is the effective date of the modification.

The scenario below, reprinted from Example 21, Case A, in ASC 842-10-55, illustrates the modification of an operating lease to a sales-type lease.

ASC 842-10

Example 21 — Modification of an Operating Lease That Changes Lease Classification

Case A — Operating Lease to Sales-Type Lease

55-194 Lessor enters into a four-year lease of a piece of nonspecialized equipment. The annual lease payments are $81,000 in the first year, increasing by 5 percent each year thereafter, payable in arrears. The estimated residual value of the equipment is $90,000, of which none is guaranteed. The remaining economic life of the equipment at lease commencement is seven years. The carrying amount of the equipment and its fair value are both $425,000 at the commencement date. The lease is not for a major part of the remaining economic life of the equipment, and the present value of the lease payments is not substantially all of the fair value of the equipment. Furthermore, title does not transfer to Lessee as a result of the lease, the lease does not contain an option for Lessee to purchase the underlying asset, and because the asset is nonspecialized, it is expected to have an alternative use to Lessor at the end of the lease term. Consequently, the lease is classified as an operating lease.

55-195 At the beginning of Year 3, Lessee and Lessor agree to extend the lease term by two years. That is, the modified lease is now a six-year lease, as compared with the original four-year lease. The additional two years were not an option when the original lease was negotiated. The modification alters the Lessee’s right to use the equipment; it does not grant Lessee an additional right of use. Therefore, Lessor does not account for the modification as a separate contract from the original four-year lease contract.

55-196 On the effective date of the modification, the fair value of the equipment is $346,250, and the remaining economic life of the equipment is 5 years. The estimated residual value of the equipment is $35,000, of which none is guaranteed. The modified lease is for a major part of the remaining economic life of the equipment at the effective date of the modification (four years out of the five-year-remaining economic life of the equipment). Consequently, the modified lease is classified as a sales-type lease.

55-197 In accounting for the modification, Lessor determines the discount rate for the modified lease (that is, the rate implicit in the modified lease) to be 7.6 percent. Lessor recognizes the net investment in the modified lease of $346,250 and derecognizes both the accrued rent and the equipment at the effective date of the modification. Lessor also recognizes, in accordance with paragraph 842-10-25-15(b), selling profit of $34,169 ($320,139 lease receivable – $8,510 accrued rent balance – the $277,460 carrying amount of the equipment derecognized, net of the unguaranteed residual asset [$277,460 = $303,571 – $26,111]). After the effective date of the modification, Lessor accounts for the modified lease in the same manner as any other sales-type lease in accordance with Subtopic 842-30.

Step 1: Gather the Facts

Lease term: 4 years.
Lease payments: $81,000 in first year, increasing by 5 percent each year thereafter.
Expected residual value of the equipment: $90,000.
Collection of the lease payments and residual value guarantee as of commencement is probable.
Remaining economic life of equipment is 7 years.
Carrying amount: $425,000.
Fair value: $425,000.
No transfer of ownership and no purchase options; lease term not for major part of economic life.
Lessor incurred no initial direct costs.

Step 2: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate in such a way that the sum equals the fair value of the asset.

Step 3: Determine the Lease Classification

The lessor would apply the criteria in ASC 842-10-25-2 to determine whether the lease is a sales-type lease:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. The remaining economic life of the equipment is seven years and the lease term is four years. Management concludes that this does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $339,038. As it is required to do in performing the sales-type lease classification test, a lessor must include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($425,000).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because none of the above criteria are met, the lease is not a sales-type lease. The lessor would then apply the criteria in ASC 842-10-25-3(b) to determine whether the lease is a direct financing lease:

ASC 842-10-25-3(b)(1) — Does the present value of the sum of the lease payments and a residual value guaranteed by a third party equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the sum of the lease payments is $339,038, and the lessee does not provide any residual value guarantees that are not already reflected in the lease payments. There are no residual value guarantees provided by third parties. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($425,000).
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?	Yes.

Because these two criteria are not met, the lease is not a direct financing lease and is an operating lease.

Step 4: Record the Commencement-Date Journal Entries

Because no assets are derecognized, there are no entries on the commencement date.

Step 5: Record Entries for Years 1 and 2

Because collectibility is probable, the lessor recognizes lease payments on a straight-line basis. The sum of the lease payments (including the 5 percent adjustment) is $349,120. The amount divided by the term of the lease (4 years) is $87,280. The year 1 and year 2 entries are as follows:

Step 6: Gather the Facts for the Modification as of the Beginning of Year 3

Lease term is extended by 2 years (and lease payments continue to increase by 5 percent each year).
Fair value of equipment: $346,250.
Remaining economic life: 5 years.
Estimated residual value: $35,000.
Accrued rent receivable balance: $8,510.
Carrying value of asset is $303,571.

Step 7: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate in such a way that the sum equals the fair value of the asset.

Step 8: Determine the Lease Classification

The lessor would reevaluate the lease to determine whether the criteria in ASC 842-10-25-2 are met:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	Yes. Management concludes that the lease term constitutes a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	Yes. The present value of the lease payments is $320,139.23 As it is required to do in performing the sales-type lease classification test, the lessor must include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees. Management concludes that the lease payments constitute substantially all of the fair value of the asset ($346,250).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because the criterion in ASC 842-10-25-2(c) or ASC 842-10-25-2(d) is met, the lease is a sales-type lease.

Step 9: Record Journal Entries Related to the Modification

As of the effective date of the modification, the lessor must derecognize the existing net accrued rent receivable. The selling profit will be recognized immediately and represents the difference between the fair value of the underlying asset and the carrying value of the underlying asset immediately before the modification, reduced by the accrued rent receivable balance.

9.3.9.5.2 Modified Lease Is a Direct Financing Lease

ASC 842-10

The scenario below, reprinted from Example 21, Case B, in ASC 842-10-55, illustrates the modification of an operating lease to a direct financing lease. In Case B, the facts and circumstances are assumed to be the same as those for Case A in ASC 842-10-55-194 (see Section 9.3.9.5.1).

ASC 842-10

Example 21 — Modification of an Operating Lease That Changes Lease Classification

Case B — Operating Lease to Direct Financing Lease

55-198 At the beginning of Year 3, Lessee and Lessor enter into a modification to extend the lease term by 1 year, and Lessee agrees to make lease payments of $108,000 per year for each of the remaining 3 years of the modified lease. No other terms of the contract are modified. Concurrent with the execution of the modification, Lessor obtains a residual value guarantee from an unrelated third party for $40,000. Consistent with Case A (paragraphs 842-10-55-194 through 55-197), at the effective date of the modification the fair value of the equipment is $346,250, the carrying amount of the equipment is $303,571, and Lessor’s accrued rent balance is $8,510. The estimated residual value at the end of the modified lease term is $80,000. The discount rate for the modified lease is 7.356 percent.

55-199 Lessor reassesses the lease classification as of the effective date of the modification and concludes that the modified lease is a direct financing lease because none of the criteria in paragraph 842-10-25-2 and both criteria in paragraph 842-10-25-3(b) are met.

55-200 Therefore, at the effective date of the modification, Lessor recognizes a net investment in the modified lease of $312,081, which is the fair value of the equipment ($346,250) less the selling profit on the lease ($34,169 = $313,922 lease receivable – $8,510 accrued rent balance – the $271,243 carrying amount of the equipment derecognized, net of the unguaranteed residual asset [$271,243 = $303,571 – $32,328]), which is deferred as part of the net investment in the lease. After the effective date of the modification, Lessor accounts for the modified lease in the same manner as any other direct financing lease in accordance with Subtopic 842-30.

Step 1: Gather the Facts

Lease term: 4 years.
Lease payments: 81,000 in first year, increasing by 5 percent each year thereafter.
Expected residual value of the equipment: $90,000.
Collection of the lease payments and residual value guarantee as of commencement is probable.
Remaining economic life of equipment: 7 years.
Carrying amount: $425,000.
Fair value: $425,000.
No transfer of ownership and no purchase options, lease term not for major part of economic life.
Lessor incurred no initial direct costs.

Step 2: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate such that the sum equals the fair value of the asset.

Step 3: Determine the Lease Classification

The lessor applies the criteria in ASC 842-10-25-2 to determine whether the lease is a sales-type lease:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. Management concludes that the lease term does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $339,038. As it is required to do in performing the sales-type lease classification test, the lessor must include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($425,000).
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because none of the criteria above are met, the lease is not a sales-type lease. The lessor must then apply the criteria in ASC 842-10-25-3(b) to determine whether the lease is a direct financing lease:

ASC 842-10-25-3(b)(1) — Does the present value of the sum of the lease payments and a residual value guaranteed by a third party equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the sum of the lease payments is $339,038, and the lessee does not provide any residual value guarantees that are not already reflected in the lease payments. There are no residual value guarantees provided by third parties. Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($425,000).
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?	Yes.

Because these two criteria are not met, the lease is not a direct financing lease and is an operating lease.

Step 4: Record the Commencement-Date Journal Entries

Because no assets are derecognized, there are no entries on the commencement date.

Step 5: Entries for Years 1 and 2

Step 6: Gather the Facts for the Modification as of the Beginning of Year 3

Lease term is extended by 1 year.
New lease payments: $108,000/year.
Fair value of equipment: $346,250.
Carrying amount: $303,571.
Remaining economic life: 5 years.
Residual value guarantee from third party: $40,000.
Accrued rent receivable balance: $8,510.
Estimated residual value: $80,000.

Step 7: Solve for the Rate Implicit in the Lease

The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate so that the sum equals the fair value of the asset.

Step 8: Determine the Lease Classification

The lessor would reevaluate the lease to determine whether it is a sales-type lease:

ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term?	No.
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise?	No.
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset?	No. Management concludes that the lease term does not constitute a major part of the economic life of the asset.
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset?	No. The present value of the lease payments is $281,593. As it is required to do in performing the sales-type lease classification test, the lessor must only include the present value of the entire residual value guarantee provided by the lessee. There are no residual value guarantees provided by the lessee.
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease?	No, the underlying asset is not specialized.

Because none of the above criteria are met, the lease is not a sales-type lease.

The lessor must then apply the criteria in ASC 842-10-25-3(b) to determine whether the lease is a direct financing lease:

Yes. The present value of the sum of the lease payments is $281,593, and the lessee has not provided any residual value guarantees that are not already reflected in the lease payments. The present value of the residual value guarantee provided by the third party ($40,000) is $32,328. The sum of the present values of the residual value guarantees and the lease payments is $313,922.24

Management concludes that the lease payments constitute substantially all of the fair value of the asset ($346,250).

ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee?

Yes.

Because both criteria are met, the lease is a direct financing lease.

Step 9: Record Journal Entries Related to the Modification

As of the effective date of the modification, the lessor must derecognize the existing net accrued rent receivable. The lessor must also derecognize the asset and record the net investment in the lease.

The discount rate to be applied should cause the unguaranteed residual asset, guaranteed residual asset, and lease payments to equal the fair value of the asset plus any initial direct costs. In calculating the net investment in the lease, the lessor identifies the present value of the lease payments not yet received as $281,593. The present value of the unguaranteed and guaranteed residual assets the lessor expects to receive is $64,657. The fair value of the underlying asset ($346,250) is $42,679 greater than the carrying value ($303,571); when adjusted for the accrued rent receivable balance ($8,510), the net investment in the lease should be reduced by $34,169 since no selling profit is immediately recognizable for a direct financing lease.

The direct financing lease is subsequently accounted for in accordance with the guidance described in Section 9.3.8.

9.3.9.5.3 Modified Lease Is an Operating Lease

ASC 842-10

If the modified lease is classified as an operating lease, the lessor shall consider any prepaid or accrued lease rentals relating to the original lease as a part of the lease payments for the modified lease. . . .

Example 20 — Modification of an Operating Lease That Does Not Change Lease Classification

55-190 Lessor enters into a 10-year lease with Lessee for 10,000 square feet of office space. The annual lease payments are $100,000 in the first year, increasing by 5 percent each year thereafter, payable in arrears. The lease term is not for a major part of the remaining economic life of the office space (40 years), and the present value of the lease payments is not substantially all of the fair value of the office space. Furthermore, the title does not transfer to Lessee as a consequence of the lease, the lease does not contain an option for Lessee to purchase the office space, and the asset is not specialized such that it clearly has an alternative use to Lessor at the end of the lease term. Consequently, the lease is classified as an operating lease.

55-191 At the beginning of Year 6, Lessee and Lessor agree to amend the original lease for the remaining 5 years to include an additional 10,000 square feet of office space in the same building for a total annual fixed payment of $150,000. The increase in total consideration is at a discount both to the current market rate for the new 10,000 square feet of office space and in the context of that particular contract. The modified lease continues to be classified as an operating lease.

55-192 At the effective date of the modification (at the beginning of Year 6), Lessor has an accrued lease rental asset of $76,331 (rental income recognized on a straight-line basis for the first 5 years of the lease of $628,895 [$1,257,789 ÷ 10 years = $125,779 per year] less lease payments for the first 5 years of $552,564 [that is, $100,000 in Year 1, $105,000 in Year 2, $110,250 in Year 3, $115,763 in Year 4, and $121,551 in Year 5]).

55-193 Because the change in pricing of the lease is not commensurate with the standalone price for the additional right-of-use asset, Lessor does not account for the modification as a new lease, separate from the original 10-year lease. Instead, Lessor accounts for the modified lease prospectively from the effective date of the modification, recognizing the lease payments to be made under the modified lease of $750,000 ($150,000 × 5 years), net of Lessor’s accrued rent asset of $76,331, on a straight-line basis over the remaining 5-year lease term ($673,669 ÷ 5 years = $134,734 per year). At the end of the lease, Lessor will have recognized as lease income the $1,302,564 in lease payments it receives from Lessee during the 10-year lease term.

ASC 842-10-25-15(a) states that if an operating lease is modified and the modified lease is an operating lease, “the lessor shall consider any prepaid or accrued lease rentals relating to the original lease as a part of the lease payments for the modified lease.”

When a lessor has recorded an accrued rent receivable for scheduled rent increases under an operating lease, the lessor subsequently renegotiates the terms of the lease, and the modification results in an operating lease classification, the lessor should continue to amortize the accrued rent receivable over the remaining lease term as a reduction of future rental income.

Example 9-16

Assume that Lessor A leases a building to Lessee B for a 10-year period under an operating lease. The first-year lease payment is $1 million and increases by $100,000 per year for each subsequent year. Assume that the payments are allocable only to a lease component. Because of the escalation in rent, A is recognizing rental income on a straight-line basis and is recording the difference between rental income and the rent collected in years 1–5 as an accrued rent receivable.

At the end of year 5, A and B renegotiate the lease by fixing the rent amount at $1.7 million per year and extending the lease term by two years. The modification does not result in a change in lease classification. In this situation, A should continue to amortize the existing accrued rent receivable balance as a reduction of rental income on a straight-line basis over the remaining seven-year term of the new lease.

9.3.9.6 Lease Termination

If an operating lease is terminated, a lessor should write off any related balance sheet amounts (e.g., accrued rent receivable, initial direct costs) and evaluate whether the useful lives of certain lessor-owned tenant improvements should be shortened or whether the balances should be written off.

9.3.10 Subleases

ASC 842-30

35-7 If the original lessee enters into a sublease or the original lease agreement is sold or transferred by the original lessee to a third party, the original lessor shall continue to account for the lease as it did before.

See Chapter 12 for more information on subleases.

Footnotes

On the basis of the technical inquiry, we believe that, if a lessor does not analogize to the contract fulfillment guidance in ASC 340-40, it must elect to expense the costs as incurred (i.e., the lessor may not analogize to another capitalization model in another area of GAAP).

Although Section 8.6 is written from the perspective of a lessee, the concepts described also apply to lessors.

See footnote 4.

Although written from the perspective of a lessor, the concepts described in this Connecting the Dots also apply to lessees.

Since a change in the conditions of the contract has taken place that results in a change in the scope of the lease, we believe that the conclusion that a lease modification has taken place is appropriate regardless of whether a corresponding change in the contract consideration has occurred.

A partial termination occurs when the parties in an existing lease agree to terminate the lessee’s right to use (1) some of the assets under the lease (e.g., discrete pieces of equipment), (2) a portion of an asset (e.g., one of several leased floors in an office building), or (3) a portion of time (e.g., the last year in a multiyear lease).

See footnote 4.

The definition of probable in this context is that “the future event or events are likely to occur” and is aligned with the definition in ASC 450 (formerly FASB Statement 5).

This is consistent with the amendments that ASU 2018-10 made to the definition of the term “rate implicit in the lease” in the glossary of ASC 842. See Section 17.3.1.3 for further discussion of the ASU.

Accordingly, the lease would meet the criterion in ASC 842-10-25-2(e) for classification as a sales-type lease.

The lessor determined the rate it used to price the lease by discounting expected annual cash inflows of $20, plus a terminal cash inflow of $50 for the expected residual value of the asset, to the asset’s fair value of $120.

See footnote 14.

Although the beginning of Example B in ASC 842-30-55-25 states that the reader should "[a]ssume the same facts and circumstances as in Case A,” the FASB staff indicated to us that the economic life in Case B should be seven years and not nine years as stipulated in Case A.

Throughout this Roadmap, references to the “collectibility of lease payments” also should be read to include the collectibility of any residual value guarantees in the contract.

We believe that the FASB supports this view in paragraph BC102 of ASU 2016-02.

For simplicity, in this example, it is assumed that there are no residual value guarantees in the contract to consider for probability of collection.

ASC 326 includes both legacy impairment guidance moved from other Codification sections and new credit loss guidance introduced by ASU 2016-13. In addition, ASU 2016-13 amended some of the legacy guidance moved to ASC 326 from other Codification sections. See Deloitte’s June 17, 2016, Heads Up for more information about the guidance in ASU 2016-13.

See footnote 19.

See Section 9.3.9.2.4 for a discussion of the income statement classification.

The calculation of this amount is subject to rounding differences.

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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.