The terms of a lease arrangement determine how a lease is classified and the resulting income statement recognition. When the terms of a lease effectively transfer control of the underlying asset, the lease represents an in substance financed purchase (sale) of an asset and the lease is classified as a finance lease by the lessee and a sales-type lease by the lessor. When a lease does not effectively transfer control of the underlying asset to the lessee, but the lessor obtains a guarantee for the value of the asset from a third party, the lessor would classify a lease as a direct financing lease. All other leases are classified as operating leases. See
LG 7 for information on leveraged leases, a specific model applicable to certain direct financing leases. Leveraged leases are eliminated in the new standard, but leveraged leases that exist at the adoption date of the new standard are grandfathered.
Figure LG 3-1 summarizes the accounting by lessees for the different types of leases.
Figure LG 3-1
Overview of lease accounting by lessees
Statement |
Finance lease |
Operating lease |
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- Record a right-of-use asset and a lease liability
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- Record a right-of-use asset and a lease liability
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- Interest expense is determined using the effective interest method. Amortization is recorded on the right-of-use asset (usually on a straight-line basis). The periodic expense at the beginning of the lease term will generally be greater than the corresponding cash payments, but will decline over the lease term as the lease liability is reduced
- Interest and amortization expense should generally be presented separately in the income statement
- The right-of-use asset is tested for impairment in accordance with ASC 360
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- Lease expense is recorded on a straight-line basis over the lease term by adding interest expense determined using the effective interest method to the amortization of the right-of-use asset. Unlike a finance lease, amortization of the right-of-use asset is calculated as the difference between the straight-line expense and the interest expense on the lease liability for a given period
- Lease expense is presented as a single line item in operating expense in the income statement
- The right-of-use asset is tested for impairment in accordance with ASC 360
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- Repayments of principal should be classified as financing activities
- Interest on the lease liability should be classified in accordance with guidance related to interest in ASC 230
- Variable lease payments should be classified as operating activities
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- Operating lease payments should be classified as operating activities
- Operating lease payments that are capitalized as a cost bringing another asset to intended use should be classified as investing activities
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Figure LG 3-2 summarizes the accounting by lessors for the different lease types (excluding leveraged leases, which are discussed in
LG 7) and Question LG 3-1 discusses how leases between related parties should be classified.
Figure LG 3-2
Overview of lease accounting by lessors
Statement |
Sales-type lease |
Direct financing lease |
Operating lease |
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- The underlying asset is derecognized and the net investment in the lease (the sum of the present value of the future lease payments and unguaranteed residual value) is recorded
- The net investment in the lease is increased by interest income and decreased by payments collected
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- The underlying asset is derecognized and the net investment in the lease (the sum of the present value of the future lease payments and unguaranteed residual value) is recorded
- The net investment in the lease is increased by interest income and decreased by payments collected
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- The underlying asset remains on the balance sheet
- The underlying asset continues to be depreciated over its useful life, which could extend beyond the lease term
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- Selling profit or loss* is recorded at lease commencement
- Interest income is recorded based on the effective rate of interest in the lease
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- Selling profit is deferred and selling loss* is recorded at lease commencement
- Interest income is recorded based on the effective rate of interest in the lease
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- Lease revenue and depreciation expense are presented on a gross basis in the income statement
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- Cash receipts from all leases should be classified as operating activities except for entities within the scope of ASC 946 (see ASC 842-30-45-5).
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* Under these lease classification criteria, lease arrangements with variable lease payments may be classified by lessors as a sales-type or direct-financing lease. This may lead to the recognition of a selling loss (i.e., a day-one loss) by the lessor even when the overall arrangement is expected to be profitable. In response to concerns raised in the post implementation review, in order to avoid recognition of such day-one loss under
ASC 842, the FASB issued
ASU 2021-05 which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on an index or a rate) as an operating lease at the lease commencement date if classifying the lease as a sales-type lease or direct financing lease would result in recognition of a day-one loss. See
LG 10.10 for the effective date and transition requirements of
ASU 2021-05. See Example LG 4-9 for an illustration of a lease with significant variable payments.
Question LG 3-1
How should leases between related parties be classified?
PwC response
Leases between related parties should be classified like all other leases as discussed in
ASC 842-10-55-12. The classification should be based on the terms of the contract, without adjustment for provisions that may have been impacted by the related party relationship.
ASC 842-10-55-12
Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties.
The lessee and lessor should look only to legally enforceable rights when classifying the lease. In identifying the legally enforceable rights, it would be reasonable to start with a review of the written contract. However, due to the relationship between the two parties, the legal lease provisions in the written contract may be uneconomic or a detailed contract may not exist at all. If this is the case, it would be helpful to involve legal counsel to understand if there are legal rights that exist outside of a written contract. For example, within office space leased from a related party under a nonrenewable, one-year managed service arrangement, a lessee may install leasehold improvements with an economic life of five years. This may indicate that the lessee expects to use the space longer than the one-year lease term and therefore the written contract terms of the arrangement may be considered uneconomic. Furthermore, that may be a reasonable expectation given that management of the lessee and lessor often include the same decision makers. Therefore, in this case it could be helpful to involve legal counsel.
Related party leases are often embedded within other arrangements (e.g., a managed service arrangement). In those cases, the arrangement may include multiple components, including both lease and non-lease components. Therefore, once total contract consideration has been determined based on the legally enforceable rights in the arrangement, it must be allocated between the multiple components in order to determine the appropriate lease payments to be used for lease classification. The total contract consideration is allocated to each component based on relative standalone price for each component. See
LG 2.4 for further details on components.