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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
Balance sheet
  • Record a right-of-use asset and a lease liability
  • Record a right-of-use asset and a lease liability
Income statement
  • 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
  • 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
Statement of cash flows
  • 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
  • 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
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
Balance sheet
  • 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
  • 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
  • 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
Income statement
  • Selling profit or loss* is recorded at lease commencement
  • Interest income is recorded based on the effective rate of interest in the lease
  • 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
  • Lease revenue and depreciation expense are presented on a gross basis in the income statement
Statement of cash flows
  • 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).
* 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.

3.2.1 Lease commencement

ASC 840 required classification to be determined at lease inception. ASC 842 only requires the determination of whether an arrangement contains a lease at lease inception. Classification and initial measurement of right-of-use assets and lease liabilities are determined at the lease commencement date, which is defined in the ASC 842 Glossary.

Definition from ASC 842 Glossary

Commencement Date of the Lease (Commencement Date): The date on which a lessor makes an underlying asset available for use by a lessee. See paragraphs 842-10-55-19 through 55-21 for implementation guidance on the commencement date.

The FASB believes that recognition of right-of-use assets and lease liabilities at lease commencement is appropriate because prior to that date, the lessor has not yet performed under the arrangement. To illustrate, assume a lessee and lessor enter into a lease arrangement on January 1, but the lessor does not make the underlying asset available for use by the lessee until April 1 of the same year. At lease inception (January 1), the arrangement would be assessed to confirm that it contains a lease, but the initial lease classification assessment and measurement of the right-of-use asset and lease liability would occur on April 1.
Although the lease commencement date may be defined in a lease agreement, the accounting assessment should be made on the date that the lessor makes the underlying asset available for use to the lessee. For example, in many real estate leases, a lessee may obtain control over the use of the underlying asset well before it begins to use the leased asset to facilitate the completion of leasehold or other improvements. Determining when a lessor has made the underlying asset available for a lessee’s use is the key to correctly determining the commencement date. Some factors to consider are whether the asset is complete, whether a lessee has the unfettered right to enter the property and the nature of any significant improvement work being performed on the asset. The commencement date specified in the lease contract or the date when lease payments begin are not typically strong indicators of when a lessee has obtained control of the leased asset. For example, if the commencement date per the legal terms of lease agreement for a single floor in an office building has occurred and the lessee has the ability to access the floor, but does not yet control how, when, or whether the space may be used, the lease has not commenced. This could occur when a lessor permits the lessee early access to a property (e.g., to install lessee improvements) while, simultaneously, the lessor continues its own work. The lease has not commenced because the lessor has not relinquished control of the underlying asset to the lessee.
There may be instances when control of the underlying asset has been obtained by a lessee prior to lease commencement (e.g., when a lessee is involved in the construction of the underlying asset). In such cases, the lessee may be required to reflect its control over the asset prior to construction completion. If so, the lessee should account for the transaction as a sale and leaseback. See LG 6.3.2.6 for additional information.
Although lease classification is determined at the lease commencement date, in certain circumstances a reporting entity may need to reassess classification at a later date. See LG 5.3.

3.2.2 Lease components

A reporting entity must identify whether an arrangement contains multiple lease and nonlease components. See LG 2.4 for information on identifying separate lease components in a contract.
A reporting entity must individually assess the classification of each separate lease component. For example, if a reporting entity determines that a contract includes two separate lease components, the reporting entity should assess the classification of each one separately. In some cases, the classification of separate components in a single lease arrangement could differ.
A single lease component may include the right to use multiple underlying assets. When classifying a lease component with multiple underlying assets, identifying the economic life and estimating the fair value of the lease component will require judgment. See LG 3.3.3.3 and LG 3.3.4.5, respectively, for additional information.

3.2.3 Master lease agreements

A master lease agreement is a contractual arrangement that governs the terms and conditions of multiple underlying assets. Accordingly, while the terms and conditions are contractually defined at lease inception, each underlying asset subject to the agreement should be evaluated individually at the commencement of each individual lease (i.e., when the lessor makes the underlying asset available for use by the lessee). Generally, a master lease agreement will result in multiple lease commencement dates because the terms and conditions within the agreement apply to different underlying assets that are made available for use by the lessee on different dates.
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