Chapter 9 — Lessor Accounting
Chapter 9 — Lessor Accounting
9.1 Overview
ASC 842-30
05-1 This Subtopic addresses accounting by lessors for leases that have been classified as sales-type leases, direct financing leases, or operating leases in accordance with the requirements in Subtopic 842-10. Lessors should follow the requirements in this Subtopic as well as those in Subtopic 842-10.
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic; see Section 842-10-15.
This chapter discusses the different steps in a lessor’s accounting for leases. Specifically, Section 9.2 discusses classification of the various lease types and Section 9.3 addresses recognition and measurement considerations related to each of these classifications. Section 9.4 covers other lessor reporting issues. Section 9.5 covers leveraged leases.
As discussed in Chapter
1, the primary objective of the Board’s
leasing project was to require presentation of the
lessee’s off-balance-sheet liabilities. However, a
common misconception is that lessor accounting has
not changed much under the new leasing guidance.
While it is true that the lessor’s classification
and resulting accounting are largely unchanged,
there are key differences between ASC 842 and ASC
840 that companies should focus on during their
implementation of ASU 2016-02. Specific
improvements the Board made to lessor accounting
include those to align ASC 842 with (1)
enhancements made to its revenue standard,
ASU 2014-09
(codified as ASC 606), and (2) updates to key
terms related to lessee accounting.
Regarding the alignment with the revenue standard, because lessors’ adoption of
ASC 842 was after their adoption of ASC 606,
preparers need to establish the timing of changes
and how such changes should be reflected. (See
Chapter 16 for guidance on the
transition provisions of ASC 842.) Further, both
the revenue and lease models now underscore the
principle of control transfer rather than the
transfer of risks and rewards, the latter of which
was the principle under ASC 605 and ASC 840.
Although lease classification for lessees under ASC 842 is similar to that for
lessors, it is not fully symmetrical. For
instance, there are two classes of leases for a
lessee and three for a lessor. In addition,
because of the amendments made by ASU
2021-05 (see Section
9.2.1.6 for more information), the
existence of variable lease payments in a lease
sometimes could influence classification for a
lessor.
We recommend supplementing a review of this section of the Roadmap with a review of the following chapters:
- Chapter 2, which discusses how to identify whether an arrangement is within the scope of the leasing standard.
- Chapter 3, which discusses whether an arrangement is, or contains, a lease.
- Chapter 4, which discusses how to identify the separate lease components and nonlease components within a contract and how the consideration is allocated to components.
- Chapter 5, which discusses the term over which a lessor recognizes consideration related to the lease component.
- Chapter 6, which discusses the initial and subsequent measurement of consideration that must be allocated to the components identified.
The changes addressed in Chapter 4 are particularly significant for lessors, since they may
find the guidance discussed therein challenging to apply and inconsistent with ASC
840. For example, while lessors now have a practical expedient under ASU 2018-11 (see below)
to elect not to separate lease and nonlease components, lessors must meet certain
conditions to apply such an expedient. Lessors that do not elect the practical
expedient must allocate consideration in the contract to the separate lease and
nonlease components on a relative stand-alone selling price basis in a manner
consistent with ASC 606. This chapter of the Roadmap focuses on the accounting for
the lease component and presumes that the lessor has already applied the provisions
discussed in Chapter 4.
As noted above, in July 2018, the FASB issued ASU 2018-11, which contains a new practical expedient under
which lessors can elect, by class of underlying asset, not to separate lease and nonlease components,
provided that the associated nonlease component(s) otherwise would be accounted for under the revenue guidance in ASC 606 and both of the following conditions are met:
- Criterion A — The timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component.
- Criterion B — The lease component, if accounted for separately, would be classified as an operating lease.
The ASU also clarifies that the presence of a nonlease component that is
ineligible for the practical expedient does not
preclude a lessor from electing the expedient when
the criteria are met for the lease component and
any other nonlease component(s). Rather, the
lessor would account for the ineligible nonlease
component(s) separately from the combined eligible
lease and nonlease component(s).
See Section 4.3.3.2
for further details about the practical expedient
related to a lessor’s separation of lease and
nonlease components. In addition, see Section
15.3.2.4 for the disclosure
requirements, and Section 16.4.6
for the transition requirements, related to ASU
2018-11.
Connecting the Dots
Variable Consideration
While there are conceptual consistencies between ASC 606 and ASC 842, principally with respect
to their reliance on control transfer, the two standards sometimes differ in their recognition
and measurement principles. For example, under ASC 606, variable payments are estimated
and included in the transaction price subject to a constraint; under ASC 842, however, variable
lease payments not linked to an index or rate are generally excluded from the determination
of a lessor’s lease receivable. Variable consideration may be allocated in a contract to a lease
component (recognition governed by ASC 842) and a nonlease component (recognition most
likely governed by ASC 606 — see below). In paragraph BC163 of ASU 2016-02, the FASB
addresses its decisions regarding the differences between accounting for variable payments
under ASC 842 and accounting for variable consideration under ASC 606:
The Board decided that providing guidance on consideration in the contract was necessary to ensure
consistent application of the allocation guidance in Topic 842, particularly for lessors because of the
differences between how the Board decided a lessor should account for variable lease payments and
how an entity accounts for variable consideration in Topic 606. The Board concluded that accounting
for a variable payment that relates partially to a lease component (for example, a performance bonus
that relates to the leased asset and the lessor’s operation of that asset) in the same manner as a
variable lease payment (that is, with respect to recognition and measurement) will be less costly and
complex than accounting for that variable payment in accordance with the variable consideration
guidance in Topic 606.
Because an entity may be permitted to recognize revenues under ASC 606 earlier
than revenues generated from lease components, it
is critical to determine the allocation of the
consideration to the appropriate component. See
Section
4.4.2.2.1 for more information.
9.2 Lease Classification
ASC 842-10
25-1 An entity shall classify each separate lease component at the commencement date. An entity shall not reassess the lease classification after the commencement date unless the contract is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8. . . .
The five criteria that a lessor uses to
determine whether a lease is a sales-type lease are the same
as those that a lessee uses to establish whether a lease is
a finance lease. If none of those criteria are met, the
lessor evaluates whether the lease is a direct financing
lease; two criteria must be met for the lease to be
considered a direct financing lease. If neither the
sales-type lease criteria nor the direct financing lease
criteria are met, the lease is an operating lease. In
addition, because of the amendments in ASU 2021-05, even a
lease that meets one of the five criteria to be a sales-type
lease (or is classified as a direct financing lease) should
be classified as an operating lease when the lessor would
have recognized a selling loss and the arrangement includes
variable lease payments that do not depend on an index or a
rate. A lessor performs its lease classification assessment
at lease commencement (i.e., when the lessee obtains the
right to use the asset).
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The decision tree below illustrates the lessor’s classification assessment as well as the criteria that must be met for each type of lease.
Changing Lanes
Classification Date
Unlike ASC 842, ASC 840 required entities to classify leases on the basis of the
facts and circumstances present at lease inception (i.e., the date of the
lease agreement or commitment, if earlier) instead of at lease commencement
(the date on which the lessor makes an underlying asset available to the
lessee). For many entities, this is not a significant change, since there
typically is not a significant lag between lease inception and lease
commencement; however, in certain circumstances, the two dates significantly
differ. In such cases, a lessor could theoretically arrive at different
conclusions if facts and circumstances change between the dates (e.g., the
fair value of the underlying asset or the rate implicit in the lease). The
diagram below illustrates the difference between lease inception and lease
commencement.
Leveraged Leases
ASC 840 addressed a fourth type of lease, a leveraged lease.
Leveraged lease accounting was a special type of accounting that a lessor
employed for certain direct financing leases. Special accounting was
required for a leveraged lease because of the unique economic effect on the
lessor. This unique economic effect stemmed from a combination of
nonrecourse financing and a cash flow pattern that typically enabled the
lessor to recover its investment in the early years of the lease (as a
result of tax benefits generated by depreciation, interest, and ITC
deductions) and subsequently afforded it the temporary use of funds from
which additional income could be derived.
The FASB did not include leveraged leases in the guidance in
ASC 842 on lease classification. In the Background Information and Basis for
Conclusions of ASU 2016-02, the FASB addresses why it decided not to retain
leveraged leases in the new leasing model, indicating that some Board
members objected to the net presentation related to leveraged leases and
others believed that the accounting for such leases was too complex.
However, the Board decided to grandfather in existing leveraged leases given
that “there would be significant complexities relating to unwinding existing
leveraged leases” during transition. Therefore, a lessor must continue to
apply the accounting in ASC 840 for such a lease (as carried forward in ASC
842) and classify the lease as a leveraged lease provided that it enters
into the lease before the effective date of ASC 842. See Chapter 16 for a
discussion of the effective date and Section 9.5 for more information about
how to account for grandfathered leveraged leases.
Bridging the GAAP
IFRS 16 Does Not Distinguish Between
Sales-Type and Direct Financing Leases
IFRS 16 does not differentiate sales-type leases from direct
financing leases. Rather, lessors will account for leases as either
operating or finance leases, as is required under IAS 17. Although ASC 842
requires a lessor to classify a finance lease as either a sales-type or a
direct financing lease, we do not believe that there will be any differences
besides the differences between ASC 840 and IAS 17 in this area. See
Appendix B
for a summary of the differences between ASC 842 and IFRS 16.
9.2.1 Sales-Type Lease
In a sales-type lease, the lessor transfers control of the underlying asset to
the lessee. In paragraph BC93 of ASU 2016-02, the FASB acknowledges that “[e]ven
though a sales-type lease is not necessarily identical to a sale, the
transactions are economically similar (for example, because sales-type lessors
often use leasing as an alternative means to sell their assets and have no
intention of reusing or re-leasing assets leased under a sales-type lease).”
Paragraph BC93 of ASU 2016-02 further points out that the hallmark of a
sales-type lease is the recognition of “selling profit at lease commencement”
and that such recognition “is consistent with the principle of a sale in Topics
606 and 610.”
Changing Lanes
Sales-Type Leases Affected by Shift From Risks-and-Rewards Model to
Control Model
A sales-type lease results in the recognition of profit (or loss). Therefore, to
be consistent with ASC 606, the FASB decided to align the
transfer-of-control notion, as it applies to the evaluation of whether a
lease qualifies as a sales-type lease, with that in ASC 606. In
paragraph BC121 of ASU 2014-09, the Board observes:
[T]he assessment of when control has transferred
could be applied from the perspective of either the entity
selling the good or service or the customer purchasing the good
or service. Consequently, revenue could be recognized when the
seller surrenders control of a good or service or when the
customer obtains control of that good or service. Although in
many cases both perspectives lead to the same result, the Boards
decided that control should be assessed primarily from the
perspective of the customer. That perspective minimizes the risk
of an entity recognizing revenue from undertaking activities
that do not coincide with the transfer of goods or services to
the customer.
The evaluation of whether a lease qualifies as a sales-type lease therefore focuses on whether
the lessee effectively obtains control of the entire underlying asset (i.e., and not just the right
to use it) rather than whether the lessor has relinquished control. Accordingly, an arrangement
that a lessor historically classified as a sales-type lease because it transferred a portion of the
risks and rewards of the underlying asset to the lessee and a portion to a third party through
a residual value guarantee (e.g., residual value insurance) may no longer qualify as a sales-type
lease.
ASC 842-10
25-2 [A] lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
25-3A Notwithstanding the
requirements in paragraphs 842-10-25-2 through 25-3, a
lessor shall classify a lease with variable lease
payments that do not depend on an index or a rate as an
operating lease at lease commencement if classifying the
lease as a sales-type lease or a direct financing lease
would result in the recognition of a selling loss.
25-7 See paragraphs 842-10-55-2 through 55-15 for implementation guidance on lease classification.
The criteria in ASC 842-10-25-2 for a lessor’s sales-type lease classification
are identical to the criteria lessees use to identify a finance lease. (See
Section 8.1 for
a discussion of the lessee’s classification.) Therefore, the lessee’s
classification will often be similar to the lessor’s; however, as further
discussed below, there are differences between the two, such as leases with a
day 1 selling loss for the lessor or differences in the assumptions (e.g.,
residual asset value) or discount rate used (rate implicit in the lease for the
lessor and the incremental borrowing rate for the lessee).
Changing Lanes
Sales-Type Leases for Real Estate
When performing the ASC 840 lease classification test, a
lessor may have determined that a lease met the criteria used by a
lessee to identify a capital lease. However, the lessor only used those
criteria as gating criteria to further identify the classification. If
any of those criteria were met, the lessor was then required to assess
whether the underlying asset was real estate or non–real estate. If the
underlying asset was considered real estate within the scope of ASC 360,
a lease could not have been a sales-type lease unless the lease
transferred the title of the property to the lessee by the end of the
lease.
Because a lease may qualify as a sales-type lease
without a title transfer under ASC 842, more leases will qualify for
sales-type classification. ASC 842 does not distinguish between the
accounting for real estate and that for non–real estate. In paragraph
BC99 of ASU 2016-02, the FASB states, in part:
Previous GAAP included different lessor
requirements for leases of real estate (for example, a lease of
real estate could only be a sales-type lease if it transferred
title to the real estate to the lessee by the end of the lease
term) because the revenue requirements in previous GAAP for the
sale of real estate differed from the revenue requirements in
previous GAAP applicable to the sale of other assets. The
creation of Topic 606 eliminated those different revenue
accounting requirements; therefore, there is no longer a reason
for the accounting for leases of real estate to differ from the
accounting for leases of other assets.
Connecting the Dots
Real Estate Lessors Must Perform Classification Test
As discussed above, under ASC 840, real estate lessors did not spend
considerable time evaluating sales-type lease classification because
title transfer was required for a real estate lease to qualify as a
sales-type lease. However, because ASC 842 does not distinguish between
real estate leases and non-real-estate leases and does not require that
title transfer occur before a sales-type lease is recognized, real
estate lessors will need to evaluate whether leases meet the criteria
for classification as a sales-type lease.
Changing Lanes
Collectibility Does Not Affect Classification as Sales-Type
Lease
Under ASC 840, collectibility of minimum lease payments had to be reasonably predictable for a
lease to qualify as a sales-type lease. While collectibility affects recognition related to sales-type
leases under ASC 842 (discussed in Section 9.3.7.2), ASC 842 does not address collectibility with
respect to the classification of such leases. Therefore, because the classification criteria in this
regard are less strict, more leases will qualify as sales-type leases.
9.2.1.1 Transfer of Ownership at the End of the Lease Term
ASC 842-10
55-4 The criterion in paragraph 842-10-25-2(a) is met in leases that provide, upon the lessee’s performance
in accordance with the terms of the lease, that the lessor should execute and deliver to the lessee such
documents (including, if applicable, a bill of sale) as may be required to release the underlying asset from the
lease and to transfer ownership to the lessee.
55-5 The criterion in paragraph 842-10-25-2(a) also is met in situations in which the lease requires the payment
by the lessee of a nominal amount (for example, the minimum fee required by the statutory regulation to
transfer ownership) in connection with the transfer of ownership.
55-6 A provision in a lease that ownership of the underlying asset is not transferred to the lessee if the lessee
elects not to pay the specified fee (whether nominal or otherwise) to complete the transfer is an option
to purchase the underlying asset. Such a provision does not satisfy the transfer-of-ownership criterion in
paragraph 842-10-25-2(a).
If the lease transfers ownership, such as through the transfer of title at or
shortly after the end of the lease term, the above criterion in ASC
842-10-25-2(a) would be met. In substance, such a transaction is akin to a
financed purchase (i.e., the asset was purchased and financed through lease
payments). Historically, such a finance lease has been accounted for as a
sale/purchase. For example, ASC 840-10- 10-1 stated that “a lease that
transfers substantially all of the benefits and risks incident to the
ownership of property should be accounted for as . . . a sale or financing
by the lessor.” While the model has evolved from a risks-and-rewards model
(i.e., benefits and risks) to a control-based model, the principle is the
same. If the lessee is required to pay a nominal fee for title transfer, the
lease would meet the criterion in ASC 842-10-25-2(a). If paying the fee
(even in circumstances in which the fee is nominal) is optional, the lease
would not meet this criterion, although the lease should be evaluated under
the “reasonably certain purchase option” criterion in ASC 842-10-25-2(b);
see further discussion in the next section.
9.2.1.2 Purchase Option Reasonably Certain to Be Exercised
As indicated in ASC 842-10-25-2(b), when a “lease grants the lessee an option to purchase the
underlying asset,” it must be reasonably certain that the lessee will exercise that option, at which point
the lessor is required to classify the lease as a sales-type lease. “Reasonably certain” is a high threshold.
A purchase option’s exercise may be reasonably certain for many reasons (e.g., an economic compulsion
or incentive for the lessee to exercise its option). See Section 5.2.2 for a discussion of the notion of
“reasonably certain.”
ASC 842-10-55-26 includes a list of economic factors (not all-inclusive) for an entity to consider when
evaluating whether the exercise of an option is reasonably certain. Such an evaluation must include an
assessment of whether an economic compulsion exists.
The examples below demonstrate scenarios in which the lessee’s exercise of its purchase option would be reasonably certain.
Example 9-1
Entity P leases a tractor that it may purchase for $10,000 at the end of the lease term. The fair value of the tractor is expected to be $20,000 when the lease term ends. Further, P has provided the lessor with a residual value guarantee of $25,000 in the event that P does not exercise the purchase option.
Example 9-2
Entity U leases an airplane in which it installs luxury seating and a gold-plated cocktail bar, both of which add significant value to the airplane. At the end of the lease term in three years, U may purchase the airplane for an amount that is commonly paid for an airplane that does not have luxury seating and a cocktail bar. The remaining useful life of the seating and bar assets extends 20 years after the noncancelable lease term.
9.2.1.3 Major Part of the Remaining Economic Life
ASC 842-10
55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph] 842-10-25-2(c) . . . would be to conclude:
- Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset. . . .
The ASC master glossary defines economic life as “[e]ither the period over which
an asset is expected to be economically usable by one or more users or the
number of production or similar units expected to be obtained from an asset
by one or more users.” As noted above, if the “lease term is for the major
part of the remaining economic life of the underlying asset,” the lease is a
sales-type lease; however, if the lease term begins “at or near the end of
the economic life of the underlying asset,” the lessor should not use this
criterion in its evaluation. (For further discussion, see Section 9.2.1.3.1.)
ASC 840 required an entity to classify a lease on the basis
of an evaluation of, among other things, certain quantitative bright-line
thresholds. That is, under ASC 840, a lease would have been classified as a
capital lease if the lease term was 75 percent or more of the remaining
economic life of an underlying asset or if the sum of the present value of
the lease payments and the present value of any residual value guarantees
amounted to 90 percent or more of the fair value of the underlying asset.
While entities are not required to use bright lines when classifying a lease
under ASC 842, the implementation guidance in ASC 842-10-55 states that a
reasonable approach to applying the lease classification criteria in ASC 842
is to use the same bright-line thresholds as those in ASC 840. Specifically,
ASC 842-10-55-2 states the following:
When determining lease classification, one
reasonable approach to assessing the criteria in paragraphs
842-10-25-2(c) through (d) and 842-10-25-3(b)(1) would be to
conclude:
-
Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
-
A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.
-
Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.
On the basis of this implementation guidance, we would not
object if an entity were to apply ASC 840’s bright-line thresholds when
classifying a lease under ASC 842. We would expect that under such an
approach, an entity would classify a lease in accordance with the
quantitative result. That is, if an entity were to apply ASC 840’s
bright-line thresholds and determine that a lease term is equal to 76
percent of an asset’s useful life, the entity should classify the lease as a
sales-type lease. The entity should not attempt to overcome the assessment
with qualitative evidence to the contrary. Likewise, if the same entity were
to determine that a lease term is equal to 74 percent of an asset’s useful
life, the entity should classify the lease as an operating lease (provided
that other lease classification criteria are not met). We would expect that
if an entity were to decide to apply the bright-line thresholds in ASC 840
when classifying a lease, the entity would apply those thresholds
consistently to all of its leases.
9.2.1.3.1 Estimated Economic Life Versus Depreciable Life
Generally, we would expect the economic life of an asset
to correspond to its depreciable life used for financial reporting. In
accordance with ASC 360, depreciable life is calculated on the basis of
the asset’s useful life, which is similar but not identical to
the economic life an entity uses in performing the lease
classification test.
The ASC master glossary defines useful life as the
“period over which an asset is expected to contribute directly or
indirectly to future cash flows” and economic life as “[e]ither the
period over which an asset is expected to be economically usable by one
or more users or the number of production or similar units expected to
be obtained from an asset by one or more users.”
The objective of determining either the useful life or
economic life of an asset is to identify the period over which the asset
will provide benefit. The asset’s useful life represents the period over
which the reporting entity will benefit from use
of the asset. In contrast, the economic life represents the period over
which “one or more users” will benefit from use
of the asset. Therefore, the asset’s estimated depreciable life pertains
to the intended use by the current owner, whereas the estimated economic
life may encompass both the current and future owners of the asset.
This difference between the two definitions is not
relevant in many cases since a single entity (the current owner) is
often expected to use an asset for its entire life. However, depending
on the facts and circumstances, it may sometimes be appropriate for an
entity to use an estimated economic life for lease classification
purposes that is longer than the asset’s estimated depreciable life.
Example 9-3
Company X, an automobile lessor,
routinely purchases automobiles that are
economically usable for seven years. Company X
leases the automobiles to lessees for three years
and sells the automobiles after the end of the
three-year lease term. Company X may have a
supportable basis for using a three-year
depreciable life (with a correspondingly higher
salvage value) for financial reporting purposes
but a seven-year economic life for lease
classification purposes.
9.2.1.3.2 Economic Life Considerations for Land
Land has an infinite economic life and therefore could never meet the
criterion in ASC 842-10-25-2(c). Thus, the estimated economic life test
cannot be applied to a lease that only involves land or when land is
treated as a separate lease component.
9.2.1.3.3 Impact of Lessor’s Intent to Sell Leased Property at the End of the Lease Term on Determination of the Estimated Economic Life of Leased Property
As described in ASC 842-10-25-2(c), the third criterion
for classifying a lease as a sales-type lease is that the “lease term is
for the major part of the remaining economic life of the underlying
asset.” However, an entity should not use this criterion to classify the
lease “if the commencement date falls at or near the end of the economic
life of the underlying asset.”
The lessor’s intention to sell the leased property
immediately after the end of the lease term should not influence the
asset’s estimated economic life if the asset can still be used for its
intended purpose by other users. Generally, decisions concerning
economic lives for leased property will be similar to those for owned
assets. Thus, the estimated economic life of a leased asset generally
will be the same as the depreciable life of a similar asset for
financial reporting purposes (except as discussed in Section
9.2.1.3.1).
Changing Lanes
25 Percent Fair Value
Test for Land Is Removed
Under ASC 840, in classifying a lease involving
both land and a building, an entity was required to assess the
land separately from the building when (1) the lease met either
the transfer-of-ownership or the bargain-purchase-price
classification criterion or (2) the fair value of the land was
25 percent or more of the total fair value of the leased
property at lease inception. Under ASC 842, an entity would no
longer consider this “25 percent fair value” criterion in
assessing classification and therefore may identify separate
units for classification purposes (i.e., a land component and a
separate building component). See Chapter 4 for more
information on how to identify lease components.
9.2.1.3.4 Lease Agreement Covering a Group of Assets That Have Different Economic Lives
A lease contract often includes a package of equipment.
For example, an equipment lease may include virtually all pieces of
equipment necessary to operate a store (e.g., refrigeration cases, air
conditioning units, alarm and phone systems, cash registers, and store
furniture).
When pieces of equipment that have different useful
economic lives are leased in the aggregate, an entity should consider
the guidance in ASC 842-10-15-28, which states that a right to use an
asset would be considered a separate lease component when it meets the
following two criteria:
-
The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).
-
The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other.
To the extent that the above guidance does not require
separation, an entity should then consider the provisions of ASC
842-10-25-5, which indicates that “[i]f a single lease component
contains the right to use more than one underlying asset (see paragraphs
842-10-15-28 through 15-29), an entity shall consider the remaining
economic life of the predominant asset in the lease component for
purposes of applying the criterion in paragraph 842-10-25-2(c).”
Regarding the assessment of the predominant asset in a lease component,
paragraph BC74 of ASU 2016-02 states, in part:
The Board noted that assessing the predominant
asset in a lease component that includes multiple underlying
assets will be straightforward in most cases. That is, the
assessment is a qualitative one that requires entities to
conclude on what is the most important element of the lease,
which should be relatively clear in most cases. The Board also
noted that if an entity is unable to identify the predominant
asset, it may indicate that there is more than one separate
lease component in the contract.
Chapter 4 discusses, in detail, the guidance in ASC
842-10-15-28 on separating leasing components.
9.2.1.3.5 At or Near the End of the Remaining Economic Life
ASC 842-10
55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph]
842-10-25-2(c) . . . would be to conclude: . . .
b. A commencement date that falls at or near the end of the economic life of the underlying asset refers
to a commencement date that falls within the last 25 percent of the total economic life of the underlying
asset. . . .
If a lease component is at or near the end of its economic life, it is not
subject to the economic-life test. In its 2013 leasing ED, the FASB
contemplated not including this exception. Paragraph BC71 of ASU 2016-02
addresses the Board’s reasons for ultimately including the exception in
the leasing guidance and states, in part:
The exception to considering this criterion when
the lease commences at or near the end of the economic life of
the underlying asset is contrary to the lease classification
principle because a lessee can direct the use of and obtain
substantially all the remaining benefits from a significantly
used asset just the same as it can a new or slightly used asset.
However, the Board determined that an exception is appropriate
because it would be inconsistent to require that a lease
covering the last few years of an underlying asset’s economic
life be recorded as a finance lease by a lessee (or sales-type
lease by a lessor) when a similar lease of that asset earlier in
its economic life would have been classified as an operating
lease. The Board concluded that this would not appropriately
reflect the economics of those leases.
9.2.1.4 Substantially All of the Fair Value of the Underlying Asset
ASC 842-10
25-4 A lessor shall assess the criteria in paragraphs 842-10-25-2(d) . . . using the rate implicit in the lease. For purposes of assessing the criterion in paragraph 842-10-25-2(d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount.
55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph 842-10-25-2(d)] would be to conclude: . . .
c. Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.
55-8 When evaluating the lease classification criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1), the fair value of the underlying asset should be reduced by any related investment tax credit retained by the lessor and expected to be realized by the lessor.
As indicated in ASC 842-10-25-2(d), if the “present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments . . . equals or exceeds substantially all of the fair value of the underlying asset,” the lease is classified as a sales-type lease. The present value is calculated by using a discounted cash flow approach. (See Chapter 6 for details on the amounts included in this calculation.) While a lessee will generally use its incremental borrowing rate (if the rate implicit in the lease is not readily determinable) to calculate the present value of its lease payments, as discussed in Section 7.2, a lessor must use the rate implicit in the lease. The ASC master glossary defines the rate implicit in the lease as follows:
The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate
determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall
be used.
An entity may solve for the rate implicit in the lease by
using the internal-rate-of-return calculation function through either a
spreadsheet database (as shown in the example below) or another calculator
mechanism.
Example 9-4
A lessor leases a yacht with a fair
value of $256,300 to an actor for three years for an
annual payment made in arrears of $75,000. When the
actor returns the yacht, the fair value of the asset
is expected to be $90,000. Using an
internal-rate-of-return functionality, the lessor
determines that its rate implicit in the lease is
9.57 percent.
Note that, in this example, no ITCs
were received and no initial direct costs were
incurred.
Connecting the Dots
Calculating a Negative “Rate Implicit in the Lease”
We have observed situations in which the outcome of
the calculation of the “rate implicit in the lease,” which is based
on how that term is defined in ASC 842-30-20, may result in a
negative discount rate. However, at the FASB’s November 30, 2016,
meeting, the Board acknowledged that using a negative discount rate
to determine the rate implicit in the lease (as defined in ASC
842-10-20) is inappropriate. ASU 2018-10 clarifies
that lessors should use a 0 percent discount rate when measuring the
net investment in a lease if the rate implicit in the lease is
negative. See Section 17.3.1.3 for
further discussion of the ASU.
Evaluating “Substantially All”
One of the most notable aspects of ASC 842 is the
exclusion of “bright lines” (e.g., the 90 percent previously used in
the fair value test) from the lease classification tests. However,
ASC 842-10- 55-2 acknowledges that 90 percent may be an appropriate
threshold for the “substantially all” criterion. See Section 9.2.1.3 for more
information.
Changing Lanes
At or Near the End of Its Economic Life and “Substantially
All”
Under ASC 840, an entity was not allowed to use the
90 percent fair value test when classifying a lease if the beginning
of the lease term fell within the last 25 percent of the total
estimated economic life of the leased property, including earlier
years of use. However, the FASB chose to no longer include that
prohibition under ASC 842. As a result, an entity will need to
evaluate the “substantially all” criterion when classifying a lease
under ASC 842, regardless of when the lease term begins.
Evaluating 89.9 Percent Lease Payments
Under ASC 840, there were many opportunities to
create highly structured leases. Specifically, many leases were
designed so that the present value of lease payments would be 89.9
percent of the fair value. Because the FASB has taken a more
principles-based approach to classification in ASC 842, we do not
believe that an 89.9 percent present value would necessarily result
in a non-sales-type lease. However, this would depend on the
entity’s accounting policies (see Section
9.2.1.3), which should be consistently applied.
Consideration of Nonperformance-Related Default
Provisions
Some lease agreements contain nonperformance-related
default provisions that may require the lessee to purchase the
leased asset or make another payment if the lessee is in default
under such provisions. Under ASC 840, these provisions needed to be
carefully considered and often directly affected the classification
of the lease. The guidance in ASC 840 on nonperformance-related
default provisions was not carried over to
ASC 842. For more information about this issue and about lessees’
treatment of payments associated with nonperformance-related default
provisions under ASC 842, see Section 8.3.3.6. In line with
the discussion in that section, lessors should generally treat these
payments as variable and should consider the guidance in ASC 842-30.
See Section
9.3 for more information about a lessor’s treatment
of variable lease payments.
Classification of the Land Component Under ASC 840
ASC 842 diverges from ASC 840 in how both lessees
and lessors allocate consideration and classify the land component
of a lease arrangement when the entity accounts for the right to use
land separately from the other components in the contract. For more
information about how this guidance differs, see Section
4.2.2.
9.2.1.4.1 Lessor’s Consideration of Initial Direct Costs Related to the Rate Implicit in the Lease
In considering initial direct costs when calculating the
rate implicit in the lease, a lessor must first assess the appropriate
classification of the lease, starting with determination of whether the
lease meets any of the criteria in ASC 842-10-25-2 for classification as
a sales-type lease. If none of those criteria are met, the lessor is
next required to determine whether the lease must be classified as a
direct financing lease in accordance with ASC 842-10-25-3(b); if not,
the lease would be classified as an operating lease.
ASC 842-10-25-2(d), which contains one of the criteria
for sales-type lease classification, states:
The present value of the sum of the lease
payments and any residual value guaranteed by the lessee that is
not already reflected in the lease payments in accordance with
paragraph 842-10-30-5(f) equals or exceeds substantially all of
the fair value of the underlying asset.
To determine the “present value of the sum of the lease
payments and any residual value guaranteed by the lessee,” the lessor
must determine the “rate implicit in the lease.” The ASC master glossary
defines the rate implicit in the lease as follows:
The rate of interest that, at a given date,
causes the aggregate present value of (a) the lease payments and
(b) the amount that a lessor expects to derive from the
underlying asset following the end of the lease term to equal
the sum of (1) the fair value of the underlying asset minus any
related investment tax credit retained and expected to be
realized by the lessor and (2) any deferred initial direct costs
of the lessor. However, if the rate determined in accordance
with the preceding sentence is less than zero, a rate implicit
in the lease of zero shall be used.
ASC 842-10-25-4 clarifies that "[f]or purposes of
assessing the criterion in paragraph 842-10-25-2(d), a lessor shall
assume that no initial direct costs will be deferred if, at the
commencement date, the fair value of the underlying asset is different
from its carrying amount.”
As a result, when determining whether a lease is a
sales-type lease under ASC 842-10-25-2(d) (quoted above), the lessor does not include initial direct costs in its
determination of the rate implicit in the lease if the underlying
asset’s fair value differs from its carrying value.
In all other cases (i.e., when the underlying asset’s
fair value equals its carrying value in the determination of whether a
lease is a sales-type lease under ASC 842-10-25-2(d) or whether a lease
is a direct financing lease under ASC 842-10-25-3(b)), the lessor would
include initial direct costs in its
determination of the rate implicit in the lease.
With respect to initial recognition and measurement, a
lessor is required to recognize (at commencement) a net investment in
the lease for sales-type and direct financing leases. The net investment
in the lease comprises the sum of the lease receivable and any
unguaranteed residual value, both of which are measured at present value
by using the same rate implicit in the lease that was used for lease
classification purposes.
For sales-type leases, ASC 842-30-25-1(c) requires that
initial direct costs be expensed “if, at the commencement date, the fair
value of the underlying asset is different from its carrying amount.” In
these cases, because the rate implicit in the lease (as determined
during lease classification) did not include
initial direct costs because they were not eligible for deferral, those
costs are automatically excluded from the net investment in the lease
(i.e., there is no need to remove them separately).
In all other cases (i.e., when the underlying asset’s
fair value equals its carrying value in the determination of whether a
lease is a sales-type lease or whether a lease is a direct financing
lease under ASC 842-10-25-3(b)), “[i]f the fair value of the underlying
asset equals its carrying amount, initial direct costs . . . are
deferred at the commencement date and included in the measurement of the
net investment in the lease” in accordance with ASC 842-30-25-1(c).
Therefore, because the initial direct costs are eligible for deferral
and were included in the determination of the
rate implicit in the lease for classification purposes, they are
automatically included in the rate used to calculate the net investment
in the lease.2
This is consistent with ASC 842-30-25-1(c) (sales-type lease recognition)
and ASC 842-30-25-8 (direct financing lease recognition), each of which
suggests that the rate implicit in the lease is defined in such a way
that initial direct costs eligible for deferral “are included
automatically in the net investment in the lease; there is no need to
add them separately.”
9.2.1.4.2 Unit of Account for Assessing Lease Classification
The lessor must classify a lease as a sales-type lease
if any of the lease classification criteria in ASC 842-10-25-2 are met.
This requirement differs from that in ASC 840, under which real estate
lessors needed to meet the transfer-of-title condition to qualify for
sales-type treatment.
In evaluating the criterion in ASC 842-10-25-2(d) (i.e.,
in assessing whether the lease is a sales-type lease), a multiunit real
estate lessor would use the fair value of the unit allocable to the
lease component in its present value test. In other words, the lessor
would identify the underlying asset at the level associated with the
space being leased and not beyond the identified lease component (e.g.,
at the level of a retail store in a shopping mall, not at the level of
the shopping mall itself).
Example 9-5
Lessor A leases a retail store
at the mall it owns. The fair value of the mall is
$10 million, and the fair value of the individual
retail store is $500,000. The present value of the
lease payments for the retail store is $450,000
(there is no residual value guarantee). To
determine the classification of the lease, the
lessor should compare the fair value of the
portion of the building allocable to the lease
component ($500,000) with the present value of the
lease payments ($450,000).
Connecting the Dots
ASU 2019-01 on
Acquisition Costs for Lessors That Are Not Manufacturers
or Dealers
In March 2019, the FASB issued ASU
2019-01, which provides guidance on how
lessors that are not manufacturers or dealers (qualifying
lessors) should determine the fair value of the underlying asset
and apply it to lease classification and measurement.
Specifically, for qualifying lessors, the fair value of the
underlying asset at lease commencement should be its cost,
including any acquisition costs, such as sales taxes or delivery
charges. Accordingly, many costs related to the fulfillment of
sales-type leases and direct financing leases should be
capitalized as part of the net investment in the lease for
qualifying lessors. However, if a significant lapse of time
occurs between the acquisition of the underlying asset and lease
commencement, lessors are required to determine fair value in
accordance with ASC 820, which does not include such costs.
Moreover, since this ASU does not apply to manufacturers and
dealers, such lessors are always required to determine fair
value in accordance with ASC 820. See Section 17.3.1.7 for more
information about ASU 2019-01.
9.2.1.4.3 Impracticable to Determine Fair Value
ASC 842-10
55-3 In some cases, it may not be practicable for an entity to determine the fair value of an underlying asset. In the context of this Topic, practicable means that a reasonable estimate of fair value can be made without undue cost or effort. It is a dynamic concept; what is practicable for one entity may not be practicable for another, what is practicable in one period may not be practicable in another, and what is practicable for one underlying asset (or class of underlying asset) may not be practicable for another. In those cases in which it is not practicable for an entity to determine the fair value of an underlying asset, lease classification should be determined without consideration of the criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1).
We believe it would be unlikely that a lessor would not be able to determine the
fair value of an underlying asset, including portions of larger assets.
Lessors that consider this paragraph to be applicable to their facts and
circumstances should consult their accounting advisers.
In determining whether to classify a lease as a
sales-type or direct financing lease, a lessor must determine whether
“the present value of the sum of the lease payments . . . equals or
exceeds substantially all of the fair value of the underlying asset” in
accordance with ASC 842-10-25-2(d) (see Section 9.2.1.4). Accordingly,
when classifying the lease (i.e., as a sales-type, direct financing, or
operating lease), the lessor must determine the fair value of the
underlying asset — for use in the fair value test — at the level
associated with the identified lease component (see Section
9.2.1.4.2). This level could be a portion of a larger asset,
such as a floor of an office building. If it is impracticable for a
lessor to determine the fair value of an underlying asset in accordance
with ASC 842-10-55-3, the lessor should assess the lease classification
without considering the criterion in ASC 842-10-25-2(d) and ASC
842-10-25-3(b)(1). In this context, “practicable” means that fair value
can be reasonably estimated without undue cost or effort.
Consider an example in which a lessor leases space on a
cell tower (e.g., a hanger) to a lessee. The lessor previously recorded
the entire cell tower (i.e., the larger asset) on its books, and the
hanger is considered a portion of the larger asset. The lessor has a
practice of leasing individual hangers within the cell tower to lessees;
thus, the individual hanger would be the unit of account from a leasing
perspective. A similar situation may arise when a lessor leases a floor
of a building to a lessee. The entire building (i.e., the larger asset)
is recorded on the lessor’s books. The lessor commonly leases individual
floors in the building to lessees. As stated above, when classifying the
lease, the lessor must determine the fair value of the underlying asset
for use in the fair value test — which would be at the level of the
individual hanger or individual floor in these examples — unless it is
impracticable to do so.
While ASC 842 does not address how a lessor should
determine the fair value of a portion of a larger asset, we believe that
the lessor can use various methods to determine the fair value of a
portion of a larger asset, depending on the facts and circumstances.
Because a lessor will typically be able to determine the fair value of
the entire larger asset (e.g., a cell tower or building, as described in
the examples above), it will often be appropriate to use an “allocation
approach” to allocate the fair value of the larger asset to the
respective portions of the larger asset that are being leased.
For example, the fair value of the larger asset could be
proportionately allocated — on the basis of the perceived value of the
individual leasable spaces — to the individual portions of the larger
asset that the lessor leases. When this method is used, other conditions
that may be more representative of the fair value of the leased asset
should be considered. In a building, for instance, higher floors are
often more desirable, have a higher stand-alone selling price, and are
leased at a higher cost to the lessee than lower floors. In such
circumstances, use of an appropriate allocation method would result in
the allocation of a greater fair value to the higher floors. Such an
allocation would better represent the economics of the individual lease
arrangements and better reflect the fair value of each respective
portion.
Likewise, we believe that an entity that is estimating
the fair value of a portion of a larger asset should consider the
intended use of the asset. It is also important not to confuse relative
fair value with relative construction or replacement costs. In the cell
tower example described above, while the percentage of the costs for the
individual hangers may not be disproportionately high compared with the
cost of the overall structure, it is likely that the hangers in the
aggregate account for most of the fair value of the tower since they
represent its revenue-producing parts. In other words, we would
sometimes expect the fair value of discrete portions of a larger asset
to be disproportionate compared with that of the entire asset on a space
or square-footage basis when the relative revenue-producing potential of
the discrete portions is taken into account.
We generally believe that it would be unusual for a
lessor not to be able to determine the fair value of a portion of an
underlying asset. Further, we would expect that a lessor that can
estimate the fair value of the larger asset (which will generally be the
case) would typically be able to reasonably allocate an appropriate
percentage of that fair value to the portion being leased without undo
cost or effort.
9.2.1.4.4 Residual Value Guarantees Provided for a Portfolio of Assets
ASC 842-10
55-9 Lessors may obtain residual value guarantees for a portfolio of underlying assets for which settlement is not solely based on the residual value of the individual underlying assets. In such cases, the lessor is economically assured of receiving a minimum residual value for a portfolio of assets that are subject to separate leases but not for each individual asset. Accordingly, when an asset has a residual value in excess of the “guaranteed” amount, that excess is offset against shortfalls in residual value that exist in other assets in the portfolio.
55-10 Residual value guarantees of a portfolio of underlying assets preclude a lessor from determining the amount of the guaranteed residual value of any individual underlying asset within the portfolio. Consequently, no such amounts should be considered when evaluating the lease classification criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1).
Although a lessor would consider residual value guarantees on individual leases
as part of the lease payments when performing the lease classification
test, such guarantees would generally be excluded from the test when
they are provided for a portfolio of assets under ASC 842-10-55-10.
However, as discussed below, there is a potential exception to this
rule.
Lessors often enter into lease agreements to lease
multiple similar assets to lessees. In these circumstances, lessees will
often guarantee the residual value for the group of assets being leased
(e.g., the portfolio of underlying assets) rather than that for each
individual underlying asset. ASC 842-10-55-10 states that a lessor should not consider residual value guarantees
of a portfolio of underlying assets when evaluating the lease
classification criteria, since “[r]esidual value guarantees of a
portfolio of underlying assets preclude a lessor from determining the
amount of the guaranteed residual value of any individual underlying
asset within the portfolio.”
The guidance in ASC 842 on how lessors should treat
residual value guarantees of a portfolio of underlying assets when
classifying a lease is similar to historical practice under ASC 840.
Specifically, in an inquiry, the SEC was asked to give its views on how
a lessor should apply ASC 840-10-25-1(d) and ASC 840-10-25-5 in
determining the minimum lease payments for lease classification purposes
when the lessee provided a guarantee of the aggregate residual value of
a portfolio of leased assets. ASC 840-30-S99-1 states that, in response
to this inquiry, the SEC staff indicated the following:
The SEC staff believes that residual value
guarantees of a portfolio of leased assets preclude a lessor
from determining the amount of the guaranteed residual value of
any individual leased asset within the portfolio at lease
inception and, accordingly, no such amounts should be included
in minimum lease payments.
Therefore, the general practice under ASC 840 was for a
lessor not to include residual value guarantees for a portfolio of
leased assets in the determination of minimum lease payments, since it
is not possible to identify the individual residual value guarantee for
any individual leased asset within the portfolio. Because the
classification analysis under ASC 840 was performed on an
individual-asset basis, it is rare for a lessor to include a residual
value guarantee of a portfolio of assets in the determination of minimum
lease payments. However, in certain circumstances, it is appropriate to
do so. Specifically, under ASC 840, if a group of leased assets
associated with the PRVG met the following criteria, the PRVG should be
factored into the calculation of minimum lease payments:
-
The leases commence and end at the same time.
-
The leased assets are physically similar to each other.
-
The variability associated with the expected residual values is expected to be highly correlated (i.e., one asset’s residual value is expected to be similar to that of the other assets’ residual values).
Under ASC 842, a lessor can account for a group of
leases at a portfolio level provided that (1) the leases are similar in
nature (e.g., have similar underlying assets) and (2) have identical or
nearly identical contract provisions (see Section 8.2.2). In addition,
paragraph BC120 of ASU 2016-02 states, in part:
[T]he Board decided to explicitly state that
lessees and lessors are permitted to apply the leases guidance
at a portfolio level. The Board acknowledged that an entity
would need to apply judgment in selecting the size and
composition of the portfolio in such a way that the entity
reasonably expects that the application of the leases model to
the portfolio would not differ materially from the application
of the leases model to the individual leases in that
portfolio.
Because ASC 842 can be applied at a portfolio level,
lessors have questioned whether it is appropriate for them to factor in
a residual value guarantee for a group of assets being leased when
determining the lease classification of each separate lease. We believe
that, when certain facts and circumstances exist, it may be appropriate
for a lessor to consider a PRVG for a group of assets being leased.
Consider the example below.
Example 9-6
A lessor enters into an
agreement to lease 10 physically similar laptops
to a lessee. The leases commence and end on the
same day. The agreement has no stated renewal or
purchase options. The individual assets have a
fair value at commencement of $500 each and an
expected residual value at the end of the lease
term of $150 each. The variability associated with
the expected residual value of each laptop is
expected to be highly correlated. The lessee
guarantees that the combined residual value of the
leased assets will be $1,500. If the PRVG were
excluded from the lease classification test, all
of the individual leases would be operating
leases. However, if the PRVG were included,
classification may change depending on the
attribution of the PRVG to the individual leases
in the portfolio.
We believe that, as described in the example above,
there are circumstances in which it may be acceptable for a lessor to
include a PRVG in the classification of leased assets that are subject
to a residual value guarantee for the group of assets. In such
circumstances, we would expect the PRVG to be apportioned equally to
each leased asset (e.g., $150 per laptop in the above example).
In addition, we believe that the lessor may consider a
PRVG when classifying the individual leases within a portfolio when an
arrangement meets the following criteria that were applied in practice
under ASC 840 (outlined above and repurposed below):
-
The leases commence and end at the same time.
-
The leased assets are physically similar to each other.
-
The variability associated with the expected residual values is expected to be highly correlated.
While ASC 842-10-55-10, read literally, suggests that a
PRVG should never be considered in the lessor’s determination of lease
classification, we believe that the FASB did not intend to change this
historical practice under ASC 840. Further, we believe that use of the
criteria above will result in a lease classification that is consistent
with the underlying economics of the leasing arrangement.
Changing Lanes
Classification of the Land Component Under ASC
840
ASC 842 diverges from ASC 840 in how both
lessees and lessors allocate consideration and classify the land
component of a lease arrangement when the entity accounts for
the right to use land separately from the other components in
the contract. For more information about how this guidance
differs, see Section 4.2.2.
9.2.1.5 Underlying Asset Is Specialized and Has No Alternative Use to the Lessor at the End of the Lease Term
ASC 842-10
55-7 In assessing whether an underlying asset has an alternative use to the lessor at the end of the lease term
in accordance with paragraph 842-10-25-2(e), an entity should consider the effects of contractual restrictions
and practical limitations on the lessor’s ability to readily direct that asset for another use (for example, selling
it or leasing it to an entity other than the lessee). A contractual restriction on a lessor’s ability to direct an
underlying asset for another use must be substantive for the asset not to have an alternative use to the lessor.
A contractual restriction is substantive if it is enforceable. A practical limitation on a lessor’s ability to direct
an underlying asset for another use exists if the lessor would incur significant economic losses to direct the
underlying asset for another use. A significant economic loss could arise because the lessor either would incur
significant costs to rework the asset or would only be able to sell or re-lease the asset at a significant loss. For
example, a lessor may be practically limited from redirecting assets that either have design specifications that
are unique to the lessee or that are located in remote areas. The possibility of the contract with the customer
being terminated is not a relevant consideration in assessing whether the lessor would be able to readily direct
the underlying asset for another use.
The criterion in ASC 842-10-25-2(e) states that if the “underlying asset is of such a specialized nature
that it is expected to have no alternative use to the lessor at the end of the lease term,” the lease is a
sales-type lease. When an underlying asset has no alternative use to the lessor at the end of a lease
term, it is presumed that the lessee will consume all (or substantially all) of the benefits of the asset. The
substantive lack of alternative use can be identified if there is a contractual restriction or an anticipated
significant economic loss related to directing the asset for another use.
Changing Lanes
New Lease Classification Criterion
The new lease classification criterion in ASC 842-10-25-2(e) has not been
previously applied in practice by companies that follow U.S. GAAP
and is not expected to frequently be met in isolation. We do not
believe that this criterion should be interpreted as applying to
situations in which the underlying asset is near the end of its
economic life and the lessee, by virtue of the lease, therefore has
obtained all of the use of the asset so that it has “no alternative
use.” Rather, the application of this criterion is intended to
identify situations in which the lessee uses all of the asset’s
economic benefits because the asset is so specialized for that
particular lessee that the lessor would not be expected to generate
economic benefit from the asset’s use outside of the lease.
Connecting the Dots
Meeting the Criterion in ASC 842-10-25-2(e)
It is unlikely that the criterion in ASC 842-10-25-2(e) would be met
in isolation because a lessor economically would not enter into an
arrangement in which it would not be compensated to obtain a
worthless asset at the end of a lease term. However, if a lease is
structured with entirely variable lease payments that do not depend
on an index or a rate (and the lease therefore does not meet the
criterion in ASC 842-10-25-2(d)), the lease may be more likely to
meet criterion (e) in isolation. However, if such leases result in a
selling loss, they may need to be classified as operating leases in
accordance with the amendments made by ASU 2021-05, as discussed in
the section below.
9.2.1.5.1 Significant Economic Losses to Direct an Underlying Asset for Another Use
ASC 842-10-55-7 states, in part:
A practical limitation on a lessor’s ability to
direct an underlying asset for another use exists if the lessor
would incur significant economic losses to direct the underlying
asset for another use. A significant economic loss could arise
because the lessor either would incur significant costs to
rework the asset or would only be able to sell or re-lease the
asset at a significant [economic] loss.
Although ASC 842 does not define the term “significant
economic loss,” the standard and the Background Information and Basis
for Conclusions of ASU 2016-02 discuss the term “significant economic
incentive.” When an entity has a significant economic incentive, it may
conclude that the exercise of a purchase option or renewal option is
reasonably certain in accordance with ASC 842-10-30-1 through 30-3.
Because “reasonably certain” is a high threshold in the assessment of
renewal (termination) options and purchase options (as discussed in
Section
5.2.2), we would expect the threshold for a significant
economic loss to also be high.
In addition, an entity can consider ASC 606-10-55-10
when assessing situations in which a significant loss exists. ASC
606-10-55-10 states:
A practical limitation on an entity’s ability to
direct an asset for another use exists if an entity would incur
significant economic losses to direct the asset for another use.
A significant economic loss could arise
because the entity either would incur significant costs to
rework the asset or would only be able to sell the asset at
a significant loss. For example, an entity may be
practically limited from redirecting assets that either have
design specifications that are unique to a customer or are
located in remote areas. [Emphasis added]
Example 9-7
An entity leases a highly
specialized underwater vehicle with patented
technology to another entity. The asset took three
years to produce. The lessee uses the asset to
search the deep ocean floor for buried treasure in
a remote area of the Arctic Ocean. The cost of
transporting the asset to the search site was
approximately half the cost of the asset itself,
and it is not expected that any other entity is
going to want to use that asset in that specific
location. The lessor would incur significant
losses in transporting the asset to its
manufacturing facility in Chicago at the end of
the lease term for refurbishment and redeployment.
The lessor does not believe that any other
entities would be interested in a similar use
(searching the Arctic Ocean for buried treasure),
and the asset is designed for that particular
environment and no other. As a result, the lessor
in this example would meet the criterion for
classifying the lease as a sales-type lease (i.e.,
the criterion in ASC 842-10-25-2(e)). We believe
that it is likely that other criteria for
sales-type classification (e.g., the
“substantially all of the fair value” test) would
also be met in such situations.
9.2.1.6 Lessor’s Accounting for Certain Leases With Variable Lease Payments
In July 2021, the FASB issued
ASU
2021-05, which requires a lessor to
classify a lease with variable lease payments that
do not depend on an index or rate as an operating
lease on the lease commencement date if specified
criteria are met. ASC 842-10-25-3A (added by ASU
2021-05) requires a lessor to classify a lease with
variable lease payments that do not depend on an
index or rate as an operating lease at lease
commencement if both of the following conditions are
met:
|
Because these leases will be classified as operating leases, when applying
the guidance in ASC 842-10-25-3A, the lessor would not derecognize the
underlying asset upon lease commencement but would continue to depreciate
the underlying asset over its useful life. Further, in accordance with ASC
842-30-25-11(a), the lessor would recognize fixed lease payments as “income
. . . over the lease term on a straight-line basis unless another systematic
and rational basis is more representative of the pattern in which benefit is
expected to be derived from the use of the underlying asset.” Variable lease
payments would be recognized as “income in profit or loss in the period in
which the changes in facts and circumstances on which the variable lease
payments are based occur,” as indicated in ASC 842-30-25-11(b).
Note that the ASU does not prescribe a threshold for the amount of variable
payments; the ASU’s guidance must be applied when a lease contains any
amount of variable payments (in addition to the requirement that the lessor
would have otherwise recognized a selling loss at lease commencement).
Connecting the Dots
Impacts of ASU 2021-05
We expect that, under ASU 2021-05, more lessors will
be required to classify leases as operating leases rather than as
sales-type or direct financing leases. Accordingly, additional
leases will qualify for the lessor practical expedient in ASC
842-10-15-42A, which allows lessors to combine lease and nonlease
components into a single component if certain scope requirements are
met. One of these requirements is that the underlying lease
component must be classified as an operating lease. See Section
4.3.3.2 for more information about the lessor
practical expedient. In addition, the classification as an operating
lease may allow certain sale-and-leaseback transactions to qualify
as successful sales. See Section 10.3 for more
information about evaluating sale-and-leaseback transactions.
9.2.2 Direct Financing Lease
If a lease does not meet any of the criteria for classification as a sales-type lease, the lessor must assess whether it has relinquished control of the underlying asset but has not transferred control to the lessee. The lessor would classify a lease that does not meet any of the criteria for a sales-type lease as a direct financing lease if two criteria are met, as described below.
Changing Lanes
Fewer Leases Expected to Be Direct Financing Leases
Under ASC 840, selling profit or loss was required for sales-type lease
classification; as a result, leases were often classified as direct
financing leases. ASC 842 no longer contains this requirement, so we
would expect there to be more sales-type leases and fewer direct
financing leases under ASC 842. Further, unlike ASC 840, ASC 842 does
not limit the classification of leases with selling profit or loss to
sales-type leases; direct financing leases also can give rise to selling
profit or loss under ASC 842. However, such selling profit or loss will
be recognized over the lease term as an adjustment to yield under ASC
842 (as discussed in Section 9.3.8).
Direct Financing Lease and 90 Percent of Fair Value Test
To be a direct financing lease under ASC 840, a lease
had to meet one of the capital lease criteria in ASC 840-10-25-1.
However, if a lease meets any of those criteria under ASC 842, the lease
would be a sales-type lease. A key difference between a sales-type lease
and a direct financing lease under ASC 842 is that a lessor would
include residual value guarantees from third
parties in its fair value test for direct financing leases. In
fact, the only reason a lessor could classify a lease as a direct
financing lease is because it obtains a third-party residual value
guarantee.
Bridging the GAAP
Different Treatment of Selling Profit in Direct Financing
Leases
Under ASC 842, a lessor in a direct financing lease must
defer selling profit at lease commencement and recognize it over the
lease term. In contrast, IFRS 16 requires a lessor to recognize profit
or loss in a finance lease at lease commencement. While the two
standards may significantly differ in this respect, this issue may not
arise frequently given the scarcity of leases with third-party residual
value guarantees that result in a selling profit.
9.2.2.1 Criteria
ASC 842-10
25-3 When none of the criteria in paragraph 842-10-25-2 are met: . . .
b. A lessor shall classify the lease as either a direct financing lease or an operating lease. A lessor shall
classify the lease as an operating lease unless both of the following criteria are met, in which case the
lessor shall classify the lease as a direct financing lease:
1. The present value of the sum of the lease payments and any residual value guaranteed by the lessee
that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) and/
or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of
the underlying asset.
2. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a
residual value guarantee.
25-3A
Notwithstanding the requirements in paragraphs
842-10-25-2 through 25-3, a lessor shall classify a
lease with variable lease payments that do not
depend on an index or a rate as an operating lease
at lease commencement if classifying the lease as a
sales-type lease or a direct financing lease would
result in the recognition of a selling loss.
9.2.2.1.1 First Criterion — Present Value of Lease Payments and Any Residual Value Guarantee Equals or Exceeds Substantially All of the Fair Value of the Underlying Asset
The present value of lease payments includes any payments described in ASC 842-10-30-5 (see Chapter 6). However, when determining whether a lease is a sales-type or direct financing lease, a lessor includes different amounts in the lease payments with respect to residual value guarantees. In performing the sales-type lease classification test, lessors only include the residual value guarantee provided by the lessee. The direct financing lease classification test takes it one step further and requires a lessor to include any residual value guaranteed by any third party unrelated to the lessor. When performing the direct financing lease test, an entity would apply the “substantially all” criterion in the same manner as it would when performing the sales-type classification test addressed in ASC 842-10-25-2(d) (e.g., 90 percent of the fair value). See Section 9.2.1.4 for more information.
Residual value guarantees provided for a portfolio of leased assets and not for
individual leased assets should not be included in the lessor
classification assessment, as described in Section 9.2.1.4.4.
A lease that does not meet the “substantially all” criterion in ASC
842-10-25-3(b)(1) is an operating lease.
When performing the direct financing lease
classification test as described above an entity may solve for the rate
implicit in the lease for a direct financing lease by using the
internal-rate-of-return calculation function through either a
spreadsheet database or another calculator mechanism, as described in
Section 9.2.1.4.
Example 9-8
A lessor leases a luxury tour
bus with a fair value of $7,230,589 (which equals
the bus’s carrying value) to a music group for
three years for an annual payment made in arrears
of $2,000,000. The lessor incurs $25,000 in
initial direct costs. When the music group returns
the tour bus, the fair value of the asset is
expected to be $4,023,023. Using an
internal-rate-of-return functionality, the lessor
determines that its rate implicit in the lease is
14.68 percent.
Note that, in this example, no
ITCs were received. Also, because the fair value
of the bus equals its carrying value, the initial
direct costs were included in the calculation of
the rate implicit in the lease. See Section
9.2.1.4.1 for more information about
how to consider initial direct costs in the
determination of the lease’s implicit rate.
9.2.2.1.1.1 Impact of a Lessor’s Subsequent Purchase of Residual Value Insurance on Lease Classification
Under ASC 842-10-25-3(b)(1), when a lessor
calculates lease payments to assess whether the lease should be
classified as a direct financing lease or operating lease, the
lessor must classify a lease as a direct financing lease if the
“present value of the sum of the lease payments and any residual
value guaranteed by the lessee that is not already reflected in the
lease payments . . . and/or any other third party unrelated to the
lessor equals or exceeds substantially all of the fair value of the
underlying asset.” Accordingly, if a lessor purchases residual value
insurance at the commencement of the lease, the amount of the
residual covered by the insurance would be included in the lessor’s
computation as part of the direct-financing lease classification
test. In some circumstances, a lessor may purchase residual value
insurance for property leased under an operating lease after the
commencement of that lease in an amount that would have required the
lease to be classified as a direct financing lease had that
insurance been purchased at the commencement of the lease.
A lessor’s purchase of residual value insurance from
a third party (unrelated to the lessor or the lessee) after the
commencement of the lease would not constitute a lease modification
and trigger a reevaluation of the lease’s classification in
accordance with ASC 842-10-25-8.
A lessor’s acquisition of residual value insurance
after the lease commencement date, in the absence of a change in the
lease’s provisions that the lessor and lessee mutually agree to,
does not represent a change in the lease provisions as contemplated
by the definition of a “lease modification” in ASC 842-10-20.
Accordingly, the lessor’s purchase of this insurance does not create
a modified lease (that is not a separate contract) that must be
reclassified in accordance with ASC 842-10-25-1 and ASC 842-10-25-8
through 25-10 (see Section 9.3.4 for more information).
Note that if residual value insurance from a third
party was contemplated or entered into at or near the same time of
lease commencement, the lessor should consider whether to include
this information in its lease classification assessment.
9.2.2.1.2 Second Criterion — It Is Probable That the Lessor Will Collect the Lease Payments
The second criterion for direct financing lease classification in ASC 842-10-25-3(b) indicates that it must
be “probable that the lessor will collect the lease payments plus any amount necessary to satisfy a
residual value guarantee.” In this context, collectibility is only assessed at lease commencement; changes
in collectibility will not result in a change in classification.
If the lease does not meet this criterion, the lease is an operating lease.
Connecting the Dots
Collectibility Issues Related to Concepts in ASC
606
For a contract to be within the scope of ASC
606, collectibility must be probable (step 1). Similarly, under
ASC 842, no lease-related recognition or measurement occurs when
collectibility is not probable. Therefore, ASC 606 and ASC 842
are aligned with respect to the deposit liability concept.
When the sales-type lease consideration does not
meet the probability threshold, the sale is only recognized when
either (1) the contract has been terminated and the lease
payments received from the lessee are nonrefundable or (2) the
lessor has repossessed the underlying asset, the lessor has no
further obligation under the contract to the lessee, and the
lease payments received from the lessee are nonrefundable.
The underlying principles in ASC 606 are
similar. Specifically, ASC 606-10-25-7 states:
When a contract with a customer does not
meet the criteria in paragraph 606-10-25-1 and an entity
receives consideration from the customer, the entity
shall recognize the consideration received as revenue
only when one or more of the following events have
occurred:
-
The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.
-
The contract has been terminated, and the consideration received from the customer is nonrefundable.
-
The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable.
The ongoing evaluation of (or lack thereof)
whether the lease payments and any residual value guarantees
become probable over the lease term is similar to the ongoing
assessment required by ASC 606. However, an important
distinction is that a lessor would never reassess the
probability threshold once it is met, since the single
obligation to deliver the leased asset has already been
fulfilled (i.e., there is no future performance, which may occur
in a revenue contract as future goods and services are
delivered).
9.2.3 Operating Lease
If the lease does not meet any of the five criteria for a sales-type lease or the two criteria for a direct financing lease, the lease is an operating lease.
In addition, certain leases with variable lease payments that do not depend on an
index or rate that would have been classified as sales-type or direct financing
leases, and for which the lessor would have recognized a selling loss, will also
be classified as operating leases. See Section
9.2.1.6 for more information.
Connecting the Dots
Operating Lease Classification
Lessors are required to first evaluate whether a lease is a sales-type lease; if
the lease is not a sales-type lease, the lessor must assess whether it
is a direct financing lease. A lessor can only conclude that a lease is
an operating lease if it does not meet the criteria for either of the
other two classifications. With the exception of the provisions of ASU
2021-05, there are no separate criteria for classifying an operating
lease.
Footnotes
1
If a lease component is at or near the end of its economic
life, it is not subject to the economic life test. See Section 9.2.1.3.1 for
more information.
2
For example, the inclusion of initial direct
costs in the determination of the rate implicit in the lease
results in a lower rate (see Cases A and C in Example 1, which
begins in ASC 842-30-55-19). This lower implicit rate applied to
the future lease payments effectively results in a higher net
investment in the lease, which inherently includes the initial
direct costs.
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:
-
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).
-
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.
-
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:
- The lease payments (as described in paragraph 842-10-30-5) not yet received by the lessor
- 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:
- The contract has been terminated, and the lease payments received from the lessee are nonrefundable.
- 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:
- The lease receivable; plus
- The carrying amount of the deposit liability; minus
- 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
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 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
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: . . .
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.
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).
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:
- The lease payments (as described in paragraph 842-10-30-5) not yet received by the lessor
- 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.
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.
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:
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 $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
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:
- 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.
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.
- 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.
|
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:
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 $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:
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 $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
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: . . .
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.
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.
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 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.
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.
- 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.
|
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:
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 $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:
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 $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.
40-3 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.
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:
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 $48,538,
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 9-15Lessor 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.
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: 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
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.
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.
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: 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
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 entries recorded for years 1 and 2 are as follows:
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:
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 $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
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:
- 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
3
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).
4
Although Section
8.6 is written from the perspective of a lessee, the concepts described also
apply to lessors.
5
See footnote
4.
6
See footnote 4.
7
Although written from the perspective of a lessor, the concepts
described in this Connecting the Dots also apply to lessees.
8
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.
9
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).
10
See footnote
4.
11
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).
12
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.
13
Accordingly, the lease would meet the criterion in ASC
842-10-25-2(e) for classification as a sales-type lease.
14
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.
15
See footnote
14.
16
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.
17
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.
18
We believe that the FASB supports this view in paragraph BC102 of ASU
2016-02.
19
For simplicity, in this example, it is assumed that there are no
residual value guarantees in the contract to consider for probability of collection.
20
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.
21
See footnote
19.
22
See Section 9.3.9.2.4 for
a discussion of the income statement classification.
23
The calculation of this amount is subject to rounding
differences.
24
The calculation of this amount is subject to rounding
differences.
9.4 Other Lessor Reporting Issues
9.4.1 Commitments to Guarantee Performance of Underlying Asset
ASC 842-10
55-33 A lessor should evaluate a commitment to guarantee performance of the underlying asset or to
effectively protect the lessee from obsolescence of the underlying asset in accordance with paragraphs
606-10-55-30 through 55-35 on warranties. If the lessor’s commitment is more extensive than a typical product
warranty, it might indicate that the commitment is providing a service to the lessee that should be accounted
for as a nonlease component of the contract.
For more information about commitments to guarantee performance of underlying
assets, see Deloitte’s Roadmap Revenue Recognition.
9.4.2 Sales of Equipment With Guaranteed Minimum Resale Amount
ASC 842-30
55-1 This implementation guidance addresses the application of the provisions of this Subtopic in the
following circumstances. A manufacturer sells equipment with an expected useful life of several years to end
users (purchasers) utilizing various sales incentive programs. Under one such sales incentive program, the
manufacturer contractually guarantees that the purchaser will receive a minimum resale amount at the time
the equipment is disposed of, contingent on certain requirements.
55-2 The manufacturer provides the guarantee by agreeing to do either of the following:
- Reacquire the equipment at a guaranteed price at specified time periods as a means to facilitate its resale
- Pay the purchaser for the deficiency, if any, between the sales proceeds received for the equipment and the guaranteed minimum resale value.
There may be dealer involvement in these types of transactions, but the minimum resale guarantee is the
responsibility of the manufacturer.
55-3 A sales incentive program in which an entity (for example, a manufacturer) contractually guarantees
that it has either a right or an obligation to reacquire the equipment at a guaranteed price (or prices) at a
specified time (or specified time periods) as a means to facilitate its resale should be evaluated in accordance
with the guidance on satisfaction of performance obligations in paragraph 606-10-25-30 and the guidance on
repurchase agreements in paragraphs 606-10-55-66 through 55-78. If that evaluation results in a lease, the
manufacturer should account for the transaction as a lease using the principles of lease accounting in Subtopic
842-10 and in this Subtopic.
55-4 A sales incentive program in which an entity (for example, a manufacturer) contractually guarantees that it
will pay a purchaser for the deficiency, if any, between the sales proceeds received for the equipment and the
guaranteed minimum resale value should be accounted for in accordance with Topic 460 on guarantees and
Topic 606 on revenue from contracts with customers.
55-5 The lease payments used as part of the determination of whether the transaction should be classified
as an operating lease, a direct financing lease, or a sales-type lease generally will be the difference between
the proceeds upon the equipment’s initial transfer and the amount of the residual value guarantee to the
purchaser as of the first exercise date of the guarantee.
55-6 If the transaction qualifies as an operating lease, the net proceeds upon the equipment’s initial transfer
should be recorded as a liability in the manufacturer’s balance sheet.
55-7 The liability is then subsequently reduced on a pro rata basis over the period to the first exercise date of the guarantee to the amount of the guaranteed residual value at that date with corresponding credits to revenue in the manufacturer’s income statement. Any further reduction in the guaranteed residual value resulting from the purchaser’s decision to continue to use the equipment should be recognized in a similar manner.
55-8 The equipment should be included in the manufacturer’s balance sheet and depreciated following the manufacturer’s normal depreciation policy.
55-9 The Impairment or Disposal of Long-Lived Assets Subsections of Subtopic 360-10 on property, plant, and equipment provide guidance on the accounting for any potential impairment of the equipment.
55-10 At the time the purchaser elects to exercise the residual value guarantee by selling the equipment to another party, the liability should be reduced by the amount, if any, paid to the purchaser. The remaining undepreciated carrying amount of the equipment and any remaining liability should be removed from the balance sheet and included in the determination of income of the period of the equipment’s sale.
55-11 Alternatively, if the purchaser exercises the residual value guarantee by selling the equipment to the manufacturer at the guaranteed price, the liability should be reduced by the amount paid to the purchaser. Any remaining liability should be included in the determination of income of the period of the exercise of the guarantee.
55-12 The accounting for a guaranteed minimum resale value is not in the scope of Topic 815 on derivatives and hedging. In the transaction described, the embedded guarantee feature is not an embedded derivative instrument that must be accounted for separately from the lease because it does not meet the criterion in paragraph 815-15-25-1(c).
55-13 Specifically, if freestanding, the guarantee feature would be excluded from the scope of paragraph 815-10-15-59(b) because of both of the following conditions:
- It is not exchange traded.
- The underlying on which settlement is based is the price of a nonfinancial asset of one of the parties, and that asset is not readily convertible to cash. It is assumed that the equipment is not readily convertible to cash, as that phrase is used in Topic 815.
55-14 Paragraph 815-10-15-59(b)(2) states that the related exception applies only if the nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the price or value of the nonfinancial asset. (In some circumstances, the exclusion in paragraph 815-10-15-63 also would apply.)
55-15 Lastly, Topic 460 on guarantees does not affect the guarantor’s accounting for the guarantee because that Topic does not apply to a guarantee for which the underlying is related to an asset of the guarantor. Because the manufacturer continues to recognize the residual value of the equipment guaranteed by the manufacturer as an asset (included in the seller-lessor’s net investment in the lease) if recording a sales-type lease, that guarantee does not meet the characteristics in paragraph 460-10-15-4 and is, therefore, not subject to the guidance in Topic 460. Additionally, if the lease is classified as an operating lease, the manufacturer does not remove the asset from its books, and its guarantee would be a market value guarantee of its own asset. A market value guarantee of the guarantor’s own asset is not within the scope of Topic 460, and the guidance in paragraphs 842-10-55-32 through 55-33 for an operating lease is not affected. As a result, the guarantor’s accounting for the guarantee is unaffected by Topic 460.
In certain arrangements, a supplier may provide a minimum resale value guarantee on equipment sold
to a customer. The guarantee may be satisfied if the manufacturer either reacquires the equipment at
a guaranteed price or pays the customer an amount representing the difference between the proceeds
from selling the equipment and the amount of the guarantee. The supplier may need to consider the
guidance in ASC 606 regarding whether the obligation to reacquire the equipment precludes sale
accounting and whether, as a result of the guarantee, the arrangement would need to be accounted for
as a lease.
For more information about whether a supplier may be required to account for the
transaction as a lease because of a right or obligation (i.e., a call option or
a forward) to reacquire an asset, see Section 2.3.1.1 or Deloitte’s Roadmap
Revenue
Recognition.
9.4.3 Accounting for Tenant Improvements and Lease Incentives
ASC 842-10
55-30 Lease incentives include both of the following:
- Payments made to or on behalf of the lessee
- Losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third party. In that circumstance, the lessor and the lessee should independently estimate any loss attributable to that assumption. For example, the lessee’s estimate of the lease incentive could be based on a comparison of the new lease with the market rental rate available for similar underlying assets or the market rental rate from the same lessor without the lease assumption. The lessor should estimate any loss on the basis of the total remaining costs reduced by the expected benefits from the sublease for use of the assumed underlying asset.
ASC 842 largely does not change the accounting for tenant improvements and lease
incentives. Lessor funding of lessee expenditures may be direct or indirect
(e.g., cash paid directly to the lessee or cash paid to third parties on behalf
of the lessee). The appropriate accounting for such lessor funding must be
determined on the basis of the substance of the arrangement. The determination
of whether amounts payable under the lease are a lease incentive should be made
on the basis of the contractual rights of the lessee and lessor as well as
considerations related to the specific asset.
Though superseded, the guidance in FASB Technical Bulletin 88-1 continues to be relevant to lease incentives by analogy. Paragraph 7 of Technical Bulletin 88-1
states, in part:
Payments made to or on behalf of the lessee represent
incentives that should be considered reductions of rental expense by the
lessee and reductions of rental revenue by the lessor over the term of
the new lease. Similarly, losses incurred by the lessor as a result of
assuming a lessee’s preexisting lease with a third party should be
considered an incentive by both the lessor and the lessee. Incentives
should be recognized on a straight-line basis over the term of the new
lease.
Further, in a February 7, 2005, letter to the Center for Public Company Audit Firms, the SEC chief accountant discussed the accounting for lease incentives as follows:
Landlord/Tenant Incentives — The staff believes that: (a) leasehold improvements made by a lessee that are funded by landlord incentives or allowances under an operating lease should be recorded by the lessee as leasehold improvement assets and amortized over a term consistent with the guidance in item 1 above; (b) the incentives should be recorded as deferred rent and amortized as reductions to lease expense over the lease term in accordance with paragraph 15 of SFAS 13 and the response to Question 2 of FASB Technical Bulletin 88-1 (“FTB 88-1”), Issues Relating to Accounting for Leases, and therefore, the staff believes it is inappropriate to net the deferred rent against the leasehold improvements; and (c) a registrant’s statement of cash flows should reflect cash received from the lessor that is accounted for as a lease incentive within operating activities and the acquisition of leasehold improvements for cash within investing activities. The staff recognizes that evaluating when improvements should be recorded as assets of the lessor or assets of the lessee may require significant judgment and factors in making that evaluation are not the subject of this letter.
ASC 842-10-55-30(b) is clear on the accounting for payments made by a landlord
to, or on behalf of, a tenant to fund items that would be an expense or
obligation of the tenant, such as moving expenses or assumption of the tenant’s
preexisting lease. However, when a landlord pays a tenant (or a third party) for
improvements, the accounting is more complicated. In some situations, such
payments may be lease incentives (e.g., leasehold improvements owned by the
lessee), which the landlord would account for as such and amortize as a
reduction of rental income over the lease term. In other situations, the
landlord may be acquiring tangible assets (e.g., tenant improvements) to lease
to the tenant, which the lessor would account for as its PP&E and depreciate
over their useful life.
If, after considering the contractual terms of the arrangement and determining
its substance, the landlord concludes that it is acquiring PP&E (e.g.,
tenant improvements) that is subject to a lease, it would be appropriate to
account for such payments to the tenant as the acquisition of PP&E. However,
notwithstanding the designation of the payment as a “tenant improvement
allowance” in the lease agreement, if it is determined that, in substance, the
landlord is not acquiring property, the landlord should account for such
payments as lease incentives. Many lease agreements contain general provisions
related to payments to fund such improvements. Such provisions may include
those:
-
Stating that the intent of the payment is to fund “tenant improvements.”
-
Indicating that title to all “tenant improvements” is transferred to the landlord as soon as the improvements are installed.
-
Requiring the tenant to provide proof of the release of mechanics liens before the payment is made.
-
Requiring the tenant to submit architectural drawings and construction plans to the landlord for approval before construction.
By themselves, these provisions are not necessarily indicative of the
arrangement’s substance and are not sufficient evidence that the landlord is
acquiring property from the tenant. For example, an agreement may specify that
the tenant intends to use the allowance to fund “tenant improvements” but (1)
may not require that the tenant provide the landlord with proof of spending for
such improvements or (2) may not otherwise provide for a mechanism under which
the landlord can monitor the tenant’s usage of the allowance. In such instances,
in the absence of other factors strongly indicating that landlord is acquiring
PP&E (see factors listed below), it generally should be presumed that the
payment to the tenant represents a lease incentive and not the acquisition of
PP&E.
In other instances, the lease arrangement may require proof of expenditures
related to improvements but give the tenant the right to retain or receive any
allowance amounts that are greater than actual improvement costs. In such
instances, in the absence of other factors strongly indicating that the landlord
is acquiring PP&E (see factors listed below), it generally should be
presumed that if a lease arrangement permits the tenant to retain this excess
allowance as either cash or as a reduction of rent, the substance of the
arrangement is that all or a portion of the allowance is a lease incentive and
not the acquisition of property. Similarly, if the tenant has discretion
regarding use of the funds received by the landlord (even if it is probable that
such funds will be used to construct tenant improvements), the arrangement may,
in substance, be the landlord’s provision of a lease incentive; in such an
arrangement, any improvements may be considered assets of the tenant for
accounting purposes.
If it is determined that, in substance, the improvements are assets of the
tenant, the landlord should treat the funding provided to the tenant as a lease
incentive in accordance with Technical Bulletin 88-1.
It is more difficult and subjective to determine the substance of a lease arrangement that does not
(1) allow the tenant to retain the excess of landlord funding over actual improvement costs, (2) give the
tenant discretion in how the allowance is spent, or (3) specifically identify the leased property as not
including the leasehold improvements.
Generally, the terms of a lease arrangement obligate the landlord to deliver the property subject to
the lease. However, the terms associated with the construction of related leasehold improvements
typically vary from arrangement to arrangement. In some circumstances, a landlord may appropriately
be considered owner of the leasehold improvements and therefore should not account for tenant
allowances as a lease incentive. Factors to consider include, but are not limited to, whether the:
- Lease agreement’s terms obligate the tenant to construct or install specifically identified assets (i.e., the leasehold improvements).
- Tenant’s failure to make specified improvements is an event of default under which the landlord can require the lessee to make those improvements or otherwise enforce the landlord’s rights to those assets (or a monetary equivalent).
- Tenant is permitted to alter or remove the leasehold improvements without the landlord’s consent or without compensating the landlord for any lost utility or diminution in fair value.
- Tenant is required to provide the landlord with evidence supporting the cost of tenant improvements before the landlord pays the tenant for the tenant improvements.
- Landlord is obligated to fund cost overruns for the construction of leasehold improvements.
- Leasehold improvements are unique to the tenant or could reasonably be used by the lessor to lease to other parties.
- Economic life of the leasehold improvements is such that a significant residual value of the assets is expected to accrue to the benefit of the landlord at the end of the lease term.
9.4.4 Accounting for Reimbursements of Repairs and Capital Improvements
Leases sometimes include provisions that require the lessor to perform routine
repairs and maintenance for the underlying asset or that permit the lessor to
make capital improvements to this asset (e.g., to replace the roof on a leased
building). The contract may also allow the lessor to collect reimbursements of
its costs for these activities from the lessee.
In determining how to account for lessee reimbursements of
lessor repairs and capital improvements, the lessor should first consider
whether its activities constitute a nonlease component of the contract. For
example, lessee reimbursements to the lessor for routine repairs to the roof of
the leased building may be part of a CAM nonlease component. See Section 4.3.1 for
detailed discussion of identifying nonlease components in a contract, including
CAMs. If the activity for which the lessor is being reimbursed represents a
nonlease component of the contract, the lessor should follow the steps outlined
in Section 4.4.2.2
by allocating the consideration in the contract to this nonlease component and
recognizing revenue in accordance with ASC 606 (or other applicable GAAP).
In other circumstances, a lessor is reimbursed for a capital
improvement that is not a nonlease component of the contract but part of the
existing lease component. For example, lessors may have lease contracts that
include provisions permitting them to charge their tenants for capital
improvements to the leased property. In these types of contracts, the capital
improvements are only made at the discretion of the lessor and the contract does
not require that the lessor make any such improvements. In many circumstances,
if the improvements are made by the lessor, the contract requires the lessee to
reimburse the lessor for these capital improvements on a straight-line basis
over the useful lives of such improvements; such reimbursements are made
proportionately with respect to the lessee’s remaining lease term. If the lessee
were to terminate the lease before the lease term expires, the lessor would have
the right to recover all rents under the lease, including any remaining
reimbursements. However, if the lessor terminates the lease early or the lease
term expires, the lessee would not have any obligation to continue reimbursing
the lessor.
Example 9-17
Lessee C enters into a 15-year lease of
a building from Lessor B. The contract gives B the right
to make capital improvements to the building and be
reimbursed by C in the manner described above.
Accordingly, at the end of year 5 of the lease, B spends
$200,000 to replace the roof of the building. Lessor B
concludes that the roof has a 20-year useful life, so it
bills C $10,000 ($200,000 cost ÷ 20-year useful life)
for reimbursement in each of the 10 years remaining in
the lease. Therefore, B will recover half of the total
cost of the roof from C by the end of the lease term.
Lessor B concludes that the roof replacement does not
constitute a nonlease component of the contract, since B
is not providing a separate good or service to C by
replacing the roof.
In the example above, provided that the lease is not modified as
a result of the capital improvement,25 B should recognize variable lease revenue for the improvement-related
reimbursements in the periods after the improvement is performed and as it
continues to provide C with the right to use the leased asset (including the new
roof), upon which reimbursement in future periods is contingent. Accordingly, B
should recognize $10,000 of variable lease revenue per year over the remaining
10 years of the lease.
Since B knows that it will have the right to recover a total of
$100,000 from C over the remaining lease term, some may argue that the condition
in ASC 842-30-25-11(b) to recognize variable lease income is met as soon as the
capital improvement is completed. However, we believe that it would be
inappropriate for B to recognize the full $100,000 of future reimbursements as
revenue when the improvement is completed because the amount is not earned at
that point in time. Rather, the reimbursements depend not only on the completion
of the new roof but also on the stipulation that B will continue to make the
underlying leased asset available for C’s use for the remaining lease term
(i.e., will continue to allow C to use the leased asset).
9.4.5 Accounting for Short Payments by Lessee
In some situations, a lessee may decide to make rent payments that are less than
the amount contractually owed under the lease contract (i.e., short payments).
In such cases, the lessee would be required to evaluate whether the terms and
conditions of the lease contract provide the lessee with an enforceable right to
make a payment less than the contractually stated amount (for example, force
majeure or other similar clauses that apply upon the occurrence of unforeseen
events or circumstances may allow the lessee to make short payments while the
situation persists). If so, the lessor would treat such short payments from the
lessee as variable lease payments (albeit negative variable lease payments). As
a result, the lessor would recognize the difference between the periodic lease
income determined at lease commencement and the revised payments from the lessee
due to short payments as variable lease revenue (albeit negative variable rent)
in the applicable period.
On the other hand, if the terms and conditions of the lease contract do not
provide the lessee with an enforceable right to make short payments, the lessor
should continue to account for the lease in accordance with its original terms,
unless the contract is modified to incorporate changes to lease payments (see
Section 9.3.4 for discussion of the
lessor’s lease modification accounting, and see Section 17.3.4 for more information about short payments related
to rent concessions resulting from COVID-19). However, short payments by the
lessee may be indicative of a change in the lessee’s credit risk, which makes it
no longer probable that the lessor will collect substantially all of the lease
payments to which it is entitled under the lease contract. (For a detailed
discussion of accounting implications associated with changes in a lessee’s
credit risk after lease commencement, see Section
9.3.7.4 for sales-type and direct financing leases and Section 9.3.9.2.1 for operating leases.)
Footnotes
25
See the Connecting the Dots in Section 9.3.4.1
for additional discussion of when a significant asset improvement may
qualify as a lease modification. If the lease is modified as a result of
the capital improvement, the reimbursements would similarly be accounted
for prospectively.
9.5 Leveraged Lease Accounting
9.5.1 History of and Accounting for Leveraged Leases
Under ASC 840, leveraged lease accounting was a special type of accounting that
a lessor applied to certain direct financing leases because of its unique economic effect
on the lessor. This unique economic effect stems from a combination of nonrecourse
financing and a cash flow pattern that typically enables the lessor to recover its
investment in the early years of the lease (as a result of tax benefits generated by
depreciation, interest, and ITC deductions) and, thereafter, affords it the temporary use
of funds from which additional income can be derived.
ASC 840-10-25-43(c) required that a lease be classified as a leveraged lease if
it had all of the following characteristics:
-
It met the criteria in ASC 840-10-25-43(b) to be classified as a direct financing lease.
-
At least three parties were involved (i.e., a long-term creditor in addition to the lessee and lessor).
-
“The financing that the long-term creditor provided was “nonrecourse as to the general credit of the lessor.”
-
The lessor’s net investment in the lease declined in the lease’s early years and rose in its later years.
The accounting for leveraged leases under ASC 840 was very complex but followed
two basic premises:
-
The lessor’s balance sheet reflected the lessor’s equity in the property on an after-tax basis, net of the related debt.
-
The lessor’s income statement reflected an after-tax constant rate of return on the lessor’s net investment. During those periods in which the net investment was zero or below zero, no income was recognized.
Bridging the GAAP
No Leveraged Lease Accounting Under IFRS
Accounting Standards
IFRS Accounting Standards do not address leveraged leases. Therefore, the
considerations in this section and the remainder of Section 9.5 do not apply to entities applying IFRS
Accounting Standards. See Appendix
B for a listing of the differences between ASC 842 and IFRS 16.
9.5.2 Impact of ASC 842 on Leveraged Lease Accounting
ASC 842-50 — Glossary
Leveraged Lease
From the perspective of a lessor, a lease that was classified as a leveraged
lease in accordance with the leases guidance in effect before the effective
date and for which the commencement date is before the effective date.
ASC 842-50
05-1 This Subtopic addresses accounting for leases that meet the definition of a leveraged lease.
ASC 842-10
65-1 . . .
z. For leases that were classified as leveraged leases in accordance
with Topic 840, and for which the commencement date is before the
effective date, a lessor shall apply the requirements in Subtopic 842-50.
If a leveraged lease is modified on or after the effective date, it shall
be accounted for as a new lease as of the effective date of the
modification in accordance with the guidance in Subtopics 842-10 and
842-30. . . .
Leases previously classified as leveraged leases under ASC 840 will be subject
to the guidance in ASC 842-50. The legacy accounting requirements are grandfathered in for
leases that were entered into and accounted for as leveraged leases before the effective
date of ASC 842. A leveraged lease modified on or after the effective date of ASC 842
would be accounted for as a new lease under the lessor model in ASC 842, which is
discussed throughout this chapter. Entities are not permitted to account for any new or
subsequently amended lease arrangements as leveraged leases after the effective date of
ASC 842.
Paragraph BC397 of ASU 2016-02 summarizes the FASB’s reasoning for eliminating leveraged lease
accounting for new leases under ASC 842 and grandfathering in the guidance for existing leveraged
leases in ASC 842-50:
The Board decided that the existing accounting model for leveraged leases should not be retained. That is, all
leases should be accounted for in a consistent manner and special rules should not exist for leases with certain
characteristics. One reason is because leveraged lease accounting provides net presentation and some Board
members do not agree with allowing a net presentation for only a subset of certain lease transactions. Another
reason is to limit some of the complexity in the lease accounting guidance by eliminating the unique accounting
for leveraged leases. As such, lessors should not distinguish leveraged leases from other leases in Topic 842.
This is consistent with the proposed requirements in the 2010 and 2013 Exposure Drafts. However, the Board
decided to grandfather existing leveraged leases during transition. Respondents to the 2013 Exposure Draft
noted that the transition of existing leveraged leases to the current lessor model would require particular
challenges when unwinding the income tax effects of the leveraged leases and income statement results on
transition that would not properly depict the economics of the transaction. The Board recognized that there
would be significant complexities relating to unwinding existing leveraged leases and that the outcome of
doing so would not be beneficial to users. Therefore, the Board decided to grandfather the accounting under
previous guidance for existing leveraged lease transactions.
ASC 842-50
15-1 This Subtopic addresses accounting for leases that meet the criteria in transition paragraph 842-10-65-1(z).
If a lessee exercises an option to extend a lease that meets the criteria in transition paragraph 842-10-65-1(z)
that it was not previously reasonably assured of exercising, the exercise of that option shall be considered a
lease modification as described in paragraph 842-10-65-1(z).
Pending Content (Transition Guidance: ASC 805-60-65-1)
15-1 This Subtopic addresses accounting for leases that
meet the criteria in transition paragraph 842-10-65-1(z). If a
lessee exercises an option to extend a lease that meets the
criteria in transition paragraph 842-10-65-1(z) that it was not
previously reasonably assured of exercising, the exercise of that
option shall be considered a lease modification as described in
paragraph 842-10-65-1(z). A joint venture formation accounted for
in accordance with Subtopic 805-60 shall apply the guidance in
this Subtopic applicable to the acquiring entity in a business
combination. The joint venture shall be viewed as analogous to the
acquiring entity in a business combination, and any recognized
businesses and/or assets shall be viewed as analogous to an
acquiree.
9.5.3 Impact of Exercising Renewal Options on Leveraged Leases
ASC 842-10-65-1(z) states that if a leveraged lease is modified after
the effective date of ASC 842, the lease would be accounted for as a new lease under ASC
842 and thus would no longer be classified as a leveraged lease. Questions have arisen
about whether a lessee’s exercise of a renewal option would constitute a lease
modification in accordance with the transition guidance related to leveraged leases in ASC
842-10-65-1(z). ASC 842-50-15-1 states, in part, “If a lessee exercises an option to
extend a lease that meets the criteria in transition paragraph 842-10-65-1(z) that it was not previously reasonably assured of exercising, the
exercise of that option shall be considered a lease modification as described in paragraph
842-10-65-1(z)” (emphasis added).
That is, to determine whether the exercise of a renewal option
represents a lease modification, a lessor should consider whether the exercised option was
previously contemplated and whether its exercise was deemed reasonably assured. In such
circumstances, the option period would have been included in the original lease
classification test and would have been reflected in the lessor’s net investment in the
lease. If the lessor previously determined that the lessee’s exercise of the renewal
option was reasonably assured, the actual exercise of the renewal option would not
represent a lease modification. Because the leveraged lease is not modified in this
scenario, the lessor would continue to account for the leveraged lease in accordance with
ASC 842-50 upon the lessee’s exercise of the renewal option.
If, on the other hand, the lessor did not previously consider the
exercise of the renewal option to be reasonably assured, the lessee’s exercise of the
renewal option would represent a lease modification in accordance with ASC 842-50-15-1. In
this case, upon the lessee’s exercise of the renewal option, the lessor would account for
the modification in accordance with ASC 842-10 and ASC 842-30 and would no longer apply
the guidance in ASC 842-50 on leveraged lease accounting.
9.5.4 Accounting for Existing Leveraged Leases Upon Adoption of ASC 842
As noted in Section
9.5.2, existing leveraged leases previously accounted for under ASC 840 will
be grandfathered in during the transition to ASC 842 and subsequently accounted for in
accordance with ASC 842-50. The guidance quoted in this section is being carried forward
from ASC 840.26
Recognition of Leveraged Leases | |
---|---|
Location of Guidance in ASC 840 | Location of Guidance in ASC 842 |
ASC 840-30-25-8 | ASC 842-50-25-1 |
ASC 840-30-25-9 | N/A — see explanation below |
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity | |
ASC 840-30-25-10 | ASC 842-50-25-2 |
ASC 842-50
General
25-1 A lessor shall record its investment in a leveraged lease. The net of the balances of the following accounts as measured in accordance with this Subtopic shall represent the lessor’s initial and continuing investment in leveraged leases:
- Rentals receivable
- Investment-tax-credit receivable
- Estimated residual value of the leased asset
- Unearned and deferred income.
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
25-2 In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall retain the
classification of the acquired entity’s investment as a lessor in a leveraged lease at the date of the combination.
The net investment of the acquired leveraged lease shall be disaggregated into its component parts, namely
net rentals receivable, estimated residual value, and unearned income including discount to adjust other
components to present value.
As noted in the table above, the existing leveraged lease guidance in ASC
840-30-25-9 was not carried forward under ASC 842. ASC 840-30-25-9 stated the
following:
If the projected net cash receipts (that is, gross cash receipts
minus gross cash disbursements exclusive of the lessor’s initial investment) over the
term of the leveraged lease are less than the lessor’s initial investment, the
deficiency shall be recognized by the lessor as a loss at lease inception.
The reason that this guidance was not carried forward under ASC 842 is because
it addressed the recognition of a loss at lease inception for leases classified as
leveraged leases. Upon adoption of ASC 842, new leases (and modified leases) will not be
classified as leveraged leases. Therefore, this guidance is no longer relevant for lessors
upon adoption of ASC 842.
Initial Measurement of Leveraged Leases | |
---|---|
Location of Guidance in ASC 840 | Location of Guidance in ASC 842 |
ASC 840-30-30-14 | ASC 842-50-30-1 |
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity | |
ASC 840-30-30-15 | ASC 842-50-30-2 |
ASC 842-50
General
30-1 A lessor shall initially measure its investment in a leveraged lease net of the nonrecourse debt (as
discussed in paragraph 842-50-25-1). The net of the balances of the following accounts shall represent the
initial and continuing investment in leveraged leases:
- Rentals receivable, net of that portion of the rental applicable to principal and interest on the nonrecourse debt.
- A receivable for the amount of the investment tax credit to be realized on the transaction.
- The estimated residual value of the leased asset. The estimated residual value shall not exceed the amount estimated at lease inception except if the lease agreement includes a provision to escalate minimum lease payments either for increases in construction or acquisition cost of the leased property or for increases in some other measure of cost or value (such as general price levels) during the construction or preacquisition period. In that case, the effect of any increases that have occurred shall be considered in the determination of the estimated residual value of the underlying asset at lease inception.
- Unearned and deferred income consisting of both of the following:
-
The estimated pretax lease income (or loss), after deducting initial direct costs, remaining to be allocated to income over the lease term.
-
The investment tax credit remaining to be allocated to income over the lease term.
-
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
30-2 In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall assign an amount to the acquired net investment in the leveraged lease in accordance with the general guidance in Topic 805 on business combinations, based on the remaining future cash flows and giving appropriate recognition to the estimated future tax effects of those cash flows.
9.5.5 Tax Considerations Related to Leveraged Leases Acquired in a Business Combination
In a business combination, an acquired entity’s individual assets and
liabilities are generally assigned fair values before taxes are considered. In accordance
with ASC 842-50-30-2, in recording a leveraged lease acquired in a business combination,
the acquiring entity should use the remaining future cash flows while “giving appropriate
recognition to the estimated future tax effects of those cash flows.” Therefore, the fair
value assigned to an acquired leveraged lease is determined on an after-tax basis (i.e.,
net of tax), and deferred taxes should not be established for temporary differences
related to acquired leveraged leases as of the acquisition date.
See ASC 842-50-55-27 through 55-33 (reproduced later in this chapter)
for an example illustrating the accounting for a leveraged lease acquired in a business
combination.
Subsequent Measurement of Leveraged Leases
| |
---|---|
Location of Guidance in ASC 840
|
Location of Guidance in ASC 842
|
Leveraged Lease Acquired in a Business Combination or an
Acquisition by a Not-for-Profit Entity
| |
ASC 840-30-35-32
|
ASC 842-50-35-1
|
Income Recognition on a Leveraged Lease
| |
ASC 840-30-35-33 through 35-36
|
ASC 842-50-35-2 through 35-5
|
Changes in Assumptions
| |
ASC 840-30-35-38 through 35-47
|
ASC 842-50-35-6 through 35-15
|
Effect of Alternative Minimum Tax
| |
ASC 840-30-35-48 through 35-52
|
ASC 842-50-35-16 through 35-20
|
Transfer of Minimum Rental Payments
| |
ASC 840-30-35-53
|
ASC 842-50-35-21
|
ASC 842-50
General
Leveraged Lease Acquired in a Business Combination or an
Acquisition by a Not-for-Profit Entity
35-1 In a business combination or an
acquisition by a not-for-profit entity, the acquiring entity shall
subsequently account for its acquired investment as a lessor in a leveraged
lease in accordance with the guidance in this Subtopic as it would for any
other leveraged lease.
Income Recognition on a Leveraged
Lease
35-2 The investment in leveraged
leases minus deferred taxes arising from differences between pretax accounting
income and taxable income shall represent the lessor’s net investment in
leveraged leases for purposes of computing periodic net income from the
leveraged lease. Given the original investment and using the projected cash
receipts and disbursements over the term of the lease, the rate of return on
the net investment in the years in which it is positive shall be computed. The
rate is that rate that, when applied to the net investment in the years in
which the net investment is positive, will distribute the net income to those
years and is distinct from the interest rate implicit in the lease. In each
year, whether positive or not, the difference between the net cash flow and
the amount of income recognized, if any, shall serve to increase or reduce the
net investment balance. The use of the term years is not intended to preclude
application of the accounting prescribed in this paragraph to shorter
accounting periods.
35-3 The net income (or loss) that a
lessor recognizes on a leveraged lease shall be composed of the following
three elements:
-
Pretax lease income (or loss)
-
Investment tax credit
-
Tax effect of pretax lease income (or loss).
35-4 The pretax lease income (or
loss) and investment tax credit elements shall be allocated in proportionate
amounts from the unearned and deferred income included in the lessor’s net
investment (as described in paragraph 842-50-30-1(d)). The tax effect of the
pretax lease income (or loss) recognized shall be reflected in tax expense for
the year. The tax effect of the difference between pretax accounting income
(or loss) and taxable income (or loss) for the year shall be charged or
credited to deferred taxes.
35-5 If, at any time during the lease
term the application of the method prescribed in this Subtopic would result in
a loss being allocated to future years, that loss shall be recognized
immediately. This situation might arise in circumstances in which one of the
important assumptions affecting net income is revised (see paragraphs
842-50-35-6 through 35-15).
Changes in Assumptions
35-6 Any estimated residual value and
all other important assumptions affecting estimated total net income from the
leveraged lease shall be reviewed at least annually. The rate of return and
the allocation of income to positive investment years shall be recalculated
from lease inception following the method described in paragraphs 842-50-35-2
through 35-4 and using the revised assumption if, during the lease term, any
of the following conditions occur:
-
The estimate of the residual value is determined to be excessive, and the decline in the residual value is judged to be other than temporary.
-
The revision of another important assumption changes the estimated total net income from the lease.
-
The projected timing of the income tax cash flows is revised.
35-7 The lessor shall update all
assumptions used to calculate total and periodic income if the lessor is
performing a recalculation of the leveraged lease. That recalculation shall
include actual cash flows up to the date of the recalculation and projected
cash flows following the date of recalculation.
35-8 The accounts constituting the
net investment balance shall be adjusted to conform to the recalculated
balances, and the change in the net investment shall be recognized as a gain
or loss in the year in which the assumption is changed. The gain or loss shall
be recognized as follows:
-
The pretax gain or loss shall be included in income from continuing operations before income taxes in the same line item in which leveraged lease income is recognized.
-
The tax effect of the gain or loss shall be included in the income tax line item.
-
An upward adjustment of the estimated residual value (including any guaranteed portion) shall not be made.
35-9 The projected timing of income
tax cash flows generated by the leveraged lease is an important assumption and
shall be reviewed annually, or more frequently, if events or changes in
circumstances indicate that a change in timing has occurred or is projected to
occur. The income effect of a change in the income tax rate shall be
recognized in the first accounting period ending on or after the date on which
the legislation effecting a rate change becomes law.
35-10 A revision of the projected
timing of the income tax cash flows applies only to changes or projected
changes in the timing of income taxes that are directly related to the
leveraged lease transaction. For example, a change in timing or projected
timing of the tax benefits generated by a leveraged lease as a result of any
of the following circumstances would require a recalculation because that
change in timing is directly related to that lease:
-
An interpretation of the tax law
-
A change in the lessor’s assessment of the likelihood of prevailing in a challenge by the taxing authority
-
A change in the lessor’s expectations about settlement with the taxing authority.
35-11 In contrast, as discussed in
paragraph 842-50-35-20, a change in timing of income taxes solely as a result
of an alternative minimum tax credit or insufficient taxable income of the
lessor would not require a recalculation of a leveraged lease because that
change in timing is not directly related to that lease. A recalculation would
not be required unless there is an indication that the previous assumptions
about total after-tax net income from the leveraged lease were no longer
valid.
35-12 Tax positions shall be
reflected in the lessor’s initial calculation or subsequent recalculation on
the recognition, measurement, and derecognition criteria in paragraphs
740-10-25-6, 740-10-30-7, and 740-10-40-2. The determination of when a tax
position no longer meets those criteria is a matter of individual facts and
circumstances evaluated in light of all available evidence.
35-13 If the lessor expects to enter
into a settlement of a tax position relating to a leveraged lease with a
taxing authority, the cash flows following the date of recalculation shall
include projected cash flows between the date of the recalculation and the
date of any projected settlement and a projected settlement amount at the date
of the projected settlement.
35-14 The recalculation of income
from the leveraged lease shall not include interest or penalties in the cash
flows from the leveraged lease.
35-15 Advance payments and deposits
made with a taxing authority shall not be considered an actual cash flow of
the leveraged lease; rather, those payments and deposits shall be included in
the projected settlement amount.
Effect of Alternative Minimum Tax
35-16 An entity shall include
assumptions about the effect of the alternative minimum tax, considering its
consolidated tax position, in leveraged lease computations.
35-17 Any difference between
alternative minimum tax depreciation and the tax depreciation assumed in the
leveraged lease or between income recognition for financial reporting purposes
and alternative minimum tax income could, depending on the lessor’s overall
tax situation, result in alternative minimum tax or the utilization of
alternative minimum tax credits.
35-18 If alternative minimum tax is
paid or an alternative minimum tax credit is utilized, the total cash flows
from the leveraged lease could be changed and the lessor’s net investment in
the leveraged lease and income recognition would be affected.
35-19 If a change to the tax
assumptions changes total estimated after-tax net income, the rate of return
on the leveraged lease shall be recalculated from inception, the accounts
constituting the lessor’s net investment shall be adjusted, and a gain or loss
shall be recognized in the year in which the assumption is changed.
35-20 However, an entity whose tax
position frequently varies between alternative minimum tax and regular tax
shall not be required to recalculate the rate of return on the leveraged lease
each year unless there is an indication that the original assumptions
regarding total after-tax net income from the lease are no longer valid. In
that circumstance, the entity shall be required to revise the leveraged lease
computations in any period in which total net income from the leveraged lease
changes because of the effect of the alternative minimum tax on cash flows for
the lease.
Transfer of Minimum Rental Payments
35-21 If a lessor sells substantially
all of the minimum rental payments associated with a leveraged lease and
retains an interest in the residual value of the leased asset, the lessor
shall not recognize increases in the value of the lease residual to its
estimated value over the remaining lease term. The lessor shall report any
remaining interest thereafter at its carrying amount at the date of the sale
of the lease payments. If it is determined subsequently that the fair value of
the residual value of the leased asset has declined below the carrying amount
of the interest retained and that decline is other than temporary, the asset
shall be written down to fair value, and the amount of the write-down shall be
recognized as a loss. That fair value becomes the asset’s new carrying amount,
and the asset shall not be increased for any subsequent increase in its fair
value before its sale or disposition.
9.5.6 Accounting for the Sale of a Leveraged Lease
ASC 842 does not specifically address the accounting for sales of
leveraged leases. ASC 842-50-35-6 states that if revisions to the significant cash flow
assumptions change the estimated total net income for the lease, the “rate of return and
the allocation of income to positive investment years shall be recalculated from lease
inception.”
The sale of a leveraged lease should not be treated as a change to the
projected cash flows of the lease and should not be accounted for in accordance with ASC
842-50-35-6. Such a sale should not be considered a revision of an important assumption
that would result in a recalculation of the estimated total net income for the lease and
affect the rate of return and the allocation of income to the positive investment years of
the lease.
9.5.7 Impact of Altering Significant Assumptions
9.5.7.1 Revised Assumptions Existing at the Inception of the Lease
Questions have arisen regarding situations in which an assumption in a
leveraged lease is altered in such a way that the lease would not have qualified as a
leveraged lease if the revised assumptions had existed at the inception of the
lease.
The appropriate accounting in such situation would depend on the
change in assumptions. First, the lessor would need to consider whether the leveraged
lease has been modified in accordance with the lease modification guidance in ASC 842
(if the lease is considered modified, leveraged lease accounting would no longer be
appropriate — see Section
9.3.4). If it is determined that the leveraged lease has not been modified,
the lease must be reviewed in accordance with ASC 842-50-35-6, which states:
Any estimated residual value and all other important assumptions
affecting estimated total net income from the leveraged lease shall be reviewed at
least annually. The rate of return and the allocation of income to positive
investment years shall be recalculated from lease inception following the method
described in paragraphs 842-50-35-2 through 35-4 and using the revised assumption
if, during the lease term, any of the following conditions occur:
-
The estimate of the residual value is determined to be excessive, and the decline in the residual value is judged to be other than temporary.
-
The revision of another important assumption changes the estimated total net income from the lease.
-
The projected timing of the income tax cash flows is revised.
Example 9-18
Assume that a lessor is in current negotiations with a
lessee regarding its leveraged lease investments. The lessor is proposing to
alter the residual value of the leased properties. The change in residual
values would be considered a change in estimate and thus would not represent
a lease modification for accounting purposes. However, the leveraged lease
would have to be reviewed in accordance with ASC 842-50-35-6 because this
might be considered an event that would affect the estimated total income
from the leveraged lease. If the estimated total income were changed, the
lessor would record the adjustment in accordance with ASC 842-50-35-6.
9.5.7.2 Impact of Altering Significant Tax Assumptions
When there is a change in income tax rates in a leveraged lease, an
entity should recalculate the lease from its inception and record any differences in
current-period earnings. In accordance with ASC 842-50-35-9, the entity would record the
effect of the tax rate change on a leveraged lease “in the first accounting period
ending on or after the date on which the legislation effecting a rate change becomes
law.” ASC 842-50-S99-1 further clarifies that the “difference between the amounts
originally recorded and the recalculated amounts must be included in income of the year
in which the tax law is enacted.”
If the timing of deductions is changed, the entity would perform a
review in accordance with ASC 842-50-35-6. On the basis of that review, if the total
estimated income is changed, the entity would recalculate (1) the estimated total net
income from the lease, (2) the rate of return, and (3) the allocation of income to
positive investment years. To recalculate these amounts, the entity would apply the
method described in ASC 842-50-35-2 through 35-5 and use the revised assumption. The
accounts constituting the net investment balance would be adjusted to conform to the
recalculated balances, and the change in the net investment would be recognized as a
gain or loss in the year in which the assumption is changed. The estimated residual
value would not be adjusted upward.
9.5.7.3 Accounting for a Change or Projected Change in the Timing of Cash Flows Related to Income Taxes Generated by a Leveraged Lease Transaction
A change or projected change in the timing of cash flows related to
income taxes generated by a leveraged lease should be accounted for in accordance with
ASC 842-50-35-6 through 35-15. Tax cash flows should be reflected in the lessor’s
initial calculation or subsequent recalculation on the basis of the recognition,
derecognition, and measurement criteria in ASC 740. The example below illustrates the
application when the only assumption that has changed is the timing of cash flows
related to income taxes generated by a leveraged lease.
Example 9-19
Assumptions:
At the inception of the arrangement, the lessor is
expected to deduct one-half of the cost of the asset in its tax returns for
each of the first two years of the lease (i.e., accelerated tax
depreciation). Accordingly, the lessor’s estimated cash flows from the
leveraged lease are as follows:
To allocate the earnings of the leveraged lease, the
lessor has to determine the rate of return necessary to distribute the net
income from the lease to only those years in which the net investment is
positive. From the following, the lessor would determine that the
appropriate rate is approximately 15.4 percent:
Accordingly, at the inception of the leveraged lease, the
lessor would record the following net accounting entries:
During the first year of the leveraged lease, the lessor
would have recorded the following net accounting entries:
Note that pre-tax income is recognized in proportion to
after-tax income. In year one, for example, $308 of $600 of after-tax income
was allocated to year one. Accordingly, 308/600 of $1,000 of pre-tax income
is recognized in year one. Also note that deferred income taxes are provided
for the difference between book and taxable income at the applicable tax
rate.
Similarly, in year two of the leveraged lease, the lessor
would record the following net accounting entries:
For illustration purposes, assume that at the end of year
two, the lessor concludes, in a manner consistent with ASC 740, that the
taxing authority is more likely than not to deny the previously taken
accelerated depreciation deduction and, rather, will require that it be
recognized on a straight-line basis over the term of the lease. As a result,
the lessor’s expected cash flows (recalculated from the inception of the
lease in accordance with the method described in ASC 842-50-35-2 through
35-4) are as follows:27
To reallocate the earnings of the leveraged lease, the
lessor has to determine the rate of return necessary to distribute the net
income from the lease to only those years in which the net investment is
positive. From the following, the lessor would determined that the
appropriate rate is approximately 6.64 percent:
At the end of year two, the lessor’s net investment in the
leveraged lease would be:
At the end of year two, after the lessor has revised its
expected timing of income-tax-related cash flows, the lessor’s net
investment in the lease should be $1,757 (not the negative $464 actually
recognized). As a result, the lessor needs to recognize a (net) $2,221
adjustment to appropriately state its net investment after determining the
effects of the revised cash flows. The accounting entries to record the net
adjustment are as follows:28
These entries have the effect of (1) revising the amount
of unearned income so that the current balance is equal to the amount that
would exist if the revised cash flows had been known at the inception of the
lease, (2) recognizing an income tax benefit attributable to the reversal of
leveraged lease income, and (3) appropriately recognizing a liability for
unrecognized tax benefits for income tax deductions taken that have not been
determined to be more likely than not to be realized.
Note that the amount of the liability for unrecognized tax
benefits to recognize should equal the tax-effected difference between the
“unrecognized tax benefit liability” basis and the “as filed” tax basis of
an asset or liability. In this example, at the end of year two, the lessor
has an as-filed tax basis of the leased equipment of $0 ($10,000 original
cost less accelerated depreciation of $10,000 over the first two years of
the lease). However, at the end of year two, the lessor concludes, on a
more-likely-than-not measurement basis, that the unrecognized tax benefit
liability basis of the leased equipment is $6,000 ($10,000 original cost
less two years of straight-line depreciation totaling $4,000). The
tax-effected difference equals $2,400, or ($0 – $6,000) × 40%.
Note that it is inappropriate to reflect the liability for
unrecognized tax benefits as a component of the lessor’s net investment in the leveraged
lease.
Presentation of Leveraged Leases
| |
---|---|
Location of Guidance in ASC
840
|
Location of Guidance in ASC
842
|
ASC 840-30-45-5
|
ASC 842-50-45-1
|
Income Taxes and Leveraged Leases
| |
ASC 840-30-45-6 and 45-7
|
ASC 842-50-45-2 and 45-3
|
ASC 842-50
General
45-1 For purposes of presenting the
investment in a leveraged lease in the lessor’s balance sheet, the amount of
related deferred taxes shall be presented separately (from the remainder of
the net investment). In the income statement or the notes to that statement,
separate presentation (from each other) shall be made of pretax income from
the leveraged lease, the tax effect of pretax income, and the amount of
investment tax credit recognized as income during the period.
45-2 Integration of the results of
income tax accounting for leveraged leases with the other results of
accounting for income taxes under Topic 740 on income taxes is required if
deferred tax credits related to leveraged leases are the only source (see
paragraph 740-10-30-18) for recognition of a tax benefit for deductible
temporary differences and carryforwards not related to leveraged leases. A
valuation allowance is not necessary if deductible temporary differences and
carryforwards will offset taxable amounts from future recovery of the net
investment in the leveraged lease. However, to the extent that the amount of
deferred tax credits for a leveraged lease as determined in accordance with
this Subtopic differs from the amount of the deferred tax liability related
to the leveraged lease that would otherwise result from applying the
guidance in Topic 740, that difference is preserved and is not a source of
taxable income for recognition of the tax benefit of deductible temporary
differences and operating loss or tax credit carryforwards.
45-3 This Subtopic requires that
the tax effect of any difference between the assigned value and the tax
basis of a leveraged lease at the date of a business combination or an
acquisition by a not-for-profit entity shall not be accounted for as a
deferred tax credit. Any tax effects included in unearned and deferred
income as required by this Subtopic shall not be offset by the deferred tax
consequences of other temporary differences or by the tax benefit of
operating loss or tax credit carryforwards. However, deferred tax credits
that arise after the date of a combination shall be accounted for in the
same manner as for leveraged leases that were not acquired in a
combination.
Pending Content (Transition Guidance: ASC 805-10-65-1)
|
---|
45-3 This Subtopic requires that the tax effect of any
difference between the assigned value and the tax basis of a
leveraged lease at the date of a business combination, an
acquisition by a not-for-profit entity, or a joint venture
formation shall not be accounted for as a deferred tax credit.
Any tax effects included in unearned and deferred income as
required by this Subtopic shall not be offset by the deferred
tax consequences of other temporary differences or by the tax
benefit of operating loss or tax credit carryforwards. However,
deferred tax credits that arise after the date of a combination
shall be accounted for in the same manner as for leveraged
leases that were not acquired in a combination.
|
Disclosure of Leveraged Leases
| |
---|---|
Location of Guidance in ASC
840
|
Location of Guidance in ASC
842
|
ASC 840-30-50-5 and 50-6
|
ASC 842-50-50-1 through 50-3
|
ASC 842-50
General
50-1 If leveraged leasing is a
significant part of the lessor’s business activities in terms of revenue,
net income, or assets, the components of the net investment balance in
leveraged leases as set forth in paragraph 842-50-25-1 shall be disclosed in
the notes to financial statements.
50-2 For guidance on disclosures
about financing receivables, which include receivables relating to a
lessor’s rights to payments from leveraged leases, see the guidance in
Subtopic 326-20 on financial instruments measured at amortized cost and
paragraph 310-10-50-31.
Pending Content (Transition Guidance: ASC 326-10-65-5)
50-2 For guidance on disclosures about financing
receivables, which include receivables relating to a lessor's
rights to payments from leveraged leases, see the guidance in
Subtopic 326-20 on financial instruments measured at amortized
cost.
50-3 If accounting for the effect
on leveraged leases of the change in tax rates results in a significant
variation from the customary relationship between income tax expense and
pretax accounting income and the reason for that variation is not otherwise
apparent, the lessor shall disclose the reason for that variation.
Implementation Guidance for Leveraged Leases
| |
---|---|
Location of Guidance in ASC
840
|
Location of Guidance in ASC
842
|
Leveraged Lease Involving an Existing Asset of a Regulated
Entity
| |
ASC 840-30-55-14
|
ASC 842-50-55-1
|
Delayed Equity Investment
| |
ASC 840-30-55-15 and 55-16
|
ASC 842-50-55-2 and 55-3
|
Income Taxes Related to Leveraged Leases
| |
ASC 840-30-55-17 and 55-18
|
ASC 842-50-55-4 and 55-5
|
Example: Lessor’s Accounting for a Leveraged Lease
| |
ASC 840-30-55-29 through 55-38
|
ASC 842-50-55-6 through 55-15
|
Example: Income Taxes Related to a Leveraged Lease
| |
ASC 840-30-55-39 through 55-46
|
ASC 842-50-55-16 through 55-23
|
Example: Effect of Advance Payments and Deposits on
Recalculation of a Leveraged Lease
| |
ASC 840-30-55-47 through 55-49
|
ASC 842-50-55-24 through 55-26
|
Example: Leveraged Lease Acquired in a Business
Combination or an Acquisition by a Not-for-Profit Entity
| |
ASC 840-30-55-50 through 55-56
|
ASC 842-50-55-27 through 55-33
|
ASC 842-50
General
Implementation Guidance
Leveraged Lease Involving an
Existing Asset of a Regulated Entity
55-1 Although the carrying amount
of an asset acquired previously may not differ significantly from its fair
value, it is unlikely that the two will be the same. However, regulated
utilities have argued that the carrying amounts of certain of their assets
always equal the fair value based on the utility’s ability to recover that
cost in conjunction with a franchise to sell a related service in a
specified area. That argument is not valid when considering the value of the
asset to a third-party purchaser that does not own that franchise.
Delayed Equity Investment
55-2 A delayed equity investment
frequently obligates the lessor to make up the shortfall between rent and
debt service in the first several years of the transaction. The type of
recourse debt resulting from the delayed equity investment does not
contradict the notion of nonrecourse and, therefore, does not preclude
leveraged lease accounting as long as other requirements of leveraged lease
accounting are met. The lessor’s related obligation should be recorded as a
liability at present value at lease inception.
55-3 Recognition of the liability
would increase the lessor’s net investment on which the lessor bases its
pattern of income recognition. While the increase to the net investment
results in an increase in income, it may be offset by the accrual of
interest on the liability.
Income Taxes Related to Leveraged
Leases
55-4 The accounting for income
taxes related to leveraged leases set forth in this Subtopic is not
consistent with the guidance in Topic 740 on income taxes.
55-5 The integration of the results
of accounting for income taxes related to leveraged leases with the other
results of accounting for income taxes as required by Topic 740 is an issue
if all of the following exist:
-
The accounting for a leveraged lease requires recognition of deferred tax credits.
-
The guidance in Topic 740 limits the recognition of a tax benefit for deductible temporary differences and carryforwards not related to the leveraged lease.
-
Unrecognized tax benefits in this paragraph could offset taxable amounts that result from future recovery of the net investment in the leveraged lease.
Example 1: Lessor’s Accounting for
a Leveraged Lease
55-6 This Example illustrates a
lessor’s accounting for a leveraged lease in accordance with the guidance in
this Subtopic. It also illustrates one way of meeting the disclosure
requirements in paragraphs 842-50-45-1 and 842-50-50-1 as applied to a
leveraged lease. The Example does not encompass all circumstances that may
arise about leveraged leases; rather, the Example is based on a single
instance of a leveraged lease. The elements of accounting and reporting
illustrated for this Example of a leveraged lease are as follows:
-
Cash flow analysis by years (see paragraph 842-50-55-8)
-
Allocation of annual cash flow to investment and income (see paragraph 842-50-55-9)
-
Journal entries for lessor’s initial investment and first year of operation (see paragraph 842-50-55-10)
-
Financial statements including notes at end of second year (see paragraph 842-50-55-11)
-
Accounting for a revision in the estimated residual value of the leased asset assumed to occur in the eleventh year of the lease (from $200,000 to $120,000):
-
Revised allocation of annual cash flow to investment and income (see paragraph 842-50-55-12)
-
Balances in investment accounts at beginning of the eleventh year before revised estimate (see paragraph 842-50-55-13)
-
Journal entries (see paragraph 842-50-55-14)
-
Adjustment of investment accounts (see paragraph 842-50-55-15).
-
55-7 This Example has the following
terms and assumptions.
55-8 Cash flow analysis by years
follows.
55-9 Allocation of annual cash flow
to investment and income follows.
55-10 Illustrative journal entries
for the year ending December 31, 1975, follow.
Lessor’s Initial Investment
First Year of Operation
Journal Entry 1
Journal Entry 2
Journal Entry 3
Journal Entry 4
Journal Entry 5
The following are notes to the illustrative financial
statements included in this Example.
Investment in Leveraged Leases
Entity is the lessor in a leveraged lease agreement entered into in
1975 under which mining equipment having an estimated economic life of
18 years was leased for a term of 15 years. Entity’s equity investment
represented 40 percent of the purchase price; the remaining 60 percent
was furnished by third-party financing in the form of long-term debt
that provides for no recourse against Entity and is secured by a first
lien on the property. At the end of the lease term, the equipment is
turned back to Entity. The residual value at that time is estimated to
be 20 percent of cost. For federal income tax purposes, Entity receives
the investment tax credit and has the benefit of tax deductions for
depreciation on the entire leased asset and for interest on the
long-term debt. During the early years of the lease, those deductions
exceed the lease rental income, and substantial excess deductions are
available to be applied against Entity’s other income. In the later
years of the lease, rental income will exceed the deductions and taxes
will be payable. Deferred taxes are provided to reflect this reversal.
Entity’s net investment in leveraged leases is composed of the following
elements.
55-12 Allocation of annual cash
flow to investment and income follows, revised to include new residual value
estimate.
55-13 Balances in investment
accounts before revised estimate of residual value follow.
Journal Entry 2
55-15 Adjustment of investment
accounts for revised estimates of residual value follows.
Example 2: Income Taxes Related to
a Leveraged Lease
55-16 This Example illustrates
integration of the results of a lessor’s income tax accounting for leveraged
leases (in accordance with the guidance in this Subtopic) with the other
results of accounting for income taxes as required by Topic 740.
55-17 At the end of Year 1 (the
current year), an entity has two temporary differences.
55-18 The first temporary
difference is for a leveraged lease that was entered into in a prior year.
During Year 1, the enacted tax rate for Year 2 and thereafter changes from
40 percent to 35 percent.
55-19 After adjusting for the
change in estimated total net income from the lease as a result of the
change in tax rates, the components of the investment in the leveraged lease
at the end of Year 1 are as follows.
55-20 The second temporary
difference is a $120,000 estimated liability for warranty expense that will
result in a tax deduction in Year 5 when the liability is expected to be
paid. Absent consideration of the deferred tax credits attributable to the
leveraged lease, the weight of available evidence indicates that a valuation
allowance is needed for the entire amount of the deferred tax asset related
to that $120,000 deductible temporary difference.
55-21 The tax basis of the
investment in the leveraged lease at the end of Year 1 is $41,000. The
amount of the deferred tax liability for that leveraged lease that would
otherwise result from the application of guidance in Topic 740 on income
taxes is determined as follows.
55-22 Loss carryback (to Year 2)
and loss carryforward (to Year 20) of the $120,000 tax deduction for
warranty expense in Year 5 would offset the $100,000 of taxable amounts
resulting from future recovery of the net investment in the leveraged lease
over the remainder of the lease term.
55-23 At the end of Year 1, the
entity recognizes a $42,000 ($120,000 at 35 percent) deferred tax asset and
a related $7,000 valuation allowance. The effect is to recognize a $35,000
net deferred tax benefit for the reduction in deferred tax credits
attributable to the leveraged lease. Deferred tax credits attributable to
the leveraged lease determined under the guidance in this Subtopic are
$39,000. However, the deferred tax liability determined is only $35,000. The
$4,000 difference is not available for offsetting.
Example 3: Effect of Advance
Payments and Deposits on Recalculation of a Leveraged Lease
55-24 This Example illustrates how
(in accordance with the guidance in paragraph 842-50-35-13 and other
paragraphs) a lessor would include advance payments and deposits in a
recalculation of a leveraged lease resulting from a determination by the
lessor that it would enter into a settlement of a tax position arising from
a leveraged lease.
55-25 This Example assumes that the
lessor has concluded that the position originally taken on the tax return
would meet the more-likely-than-not threshold in Subtopic 740-10 on income
taxes. It also assumes that the lessor would conclude that the estimate of
$50 for the projected lease-in, lease-out settlement is consistent with the
measurement guidance in that Subtopic.
55-26 A lessor makes an advance
payment of $25 on July 1, 2007, $10 of which is estimated to be associated
with issues arising from a lease-in, lease-out transaction. On July 1, 2007,
the lessor changes its assumption about the timing of the tax cash flows and
projects a settlement with the Internal Revenue Service on September 1,
2009. The projected settlement would result in a payment to the taxing
authority of $125 of which $50 is associated with the lease-in, lease-out
transaction. On July 1, 2007, when the lessor recalculates the leveraged
lease, the lessor would include a $50 cash flow on September 1, 2009, as a
projected outflow in the leveraged lease recalculation.
Example 4: Leveraged Lease Acquired
in a Business Combination or an Acquisition by a Not-for-Profit
Entity
55-27 This Example illustrates one
way that a lessor’s investment in a leveraged lease might be valued by the
acquiring entity in a business combination or an acquisition by a
not-for-profit entity and the subsequent accounting for the investment in
accordance with the guidance in this Subtopic. The elements of accounting
and reporting illustrated for this Example are as follows:
-
Acquiring entity’s cash flow analysis by years (see paragraph 842-50-55-29)
-
Acquiring entity’s valuation of investment in the leveraged lease (see paragraph 842-50-55-30)
-
Acquiring entity’s allocation of annual cash flow to investment and income (see paragraph 842-50-55-31)
-
Journal entry for recording allocation of purchase price to net investment in the leveraged lease (see paragraph 842-50-55-32)
-
Journal entries for the year ending December 31, 1984 (Year 10 of the lease) (see paragraph 842-50- 55-33).
55-28 This Example has the
following terms and assumptions.
55-29 Acquiring entity’s cash flow
analysis by years follows.
55-30 Acquiring entity’s valuation
of investment in the leveraged lease follows.
55-31 Acquiring entity’s allocation
of annual cash flow to investment and income follows (see footnote (a)).
55-32 Illustrative journal entry
for recording allocation of purchase price to net investment in the
leveraged lease follows.
55-33 Illustrative journal entries
for year ending December 31, 19Y4, follows.
Third Year of Operation After the
Business Combination (Year 10 of the Lease)
Journal Entry 1
Journal Entry 2
Journal Entry 3
Footnotes
26
There are minor grammatical differences between the leveraged lease
guidance in ASC 840 and that in ASC 842; however, such differences are minor and not
expected to result in a change in the interpretation or application of the guidance
for lessors. Therefore, those differences are not highlighted in this chapter.
27
In this example, it is assumed that the lessor did not
make any advance, deposit, or settlement payments to the tax authority
up to the date of the recalculation and that a projected settlement
amount was not included in the recalculation. ASC 842-50-35-13 provides
guidance on how, when a lessor has entered into (or expects to enter
into) a settlement with a tax authority, such payments, cash flow
projections, or both should be included in a recalculation.
28
Note that if these journal entries were being made as
of the lessor’s initial adoption of this guidance, the amounts affecting
the statement of operations would be recorded as an adjustment to the
beginning balance of retained earnings as of the beginning of the period
in which the guidance is adopted.