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3.3 Lease classification criteria

Publication date: 31 May 2023

us Leases guide 3.3

Lease classification is governed by five criteria. Although the guidance considers whether a lease is economically similar to the purchase of a nonfinancial asset from the perspective of control, the classification approach is substantially similar to previous guidance. If any of the five criteria in ASC 842-10-25-2 are met, a lessee should classify the lease as a finance lease and the lessor would classify the lease as a sales-type lease. If none of the criteria are met, a lessor would classify a lease as a direct financing lease if the criteria in ASC 842-10-25-3b are met. All other leases should be classified as an operating lease by both the lessee and lessor.

Although lessors are generally subject to the same classification criteria as lessees, additional considerations relevant to any revenue generating activity – such as the collectibility of amounts due under the lease – may impact the timing and recognition of selling profit or loss, or income over the lease term. Furthermore, under the 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.

A reporting entity that elects the exception for short-term leases would not apply the lease classification criteria. See LG 2.2.1 for information on the short-term lease measurement and recognition exemption.

Figure LG 3-3 provides the lease classification criteria contained in ASC 842-10-25-2 and ASC 842-10-25-3.

Figure LG 3-3
Lease classification criteria

Each of these types of leases are discussed in the following sections.

Question LG 3-2
If a lessee classifies a lease as a finance lease, must the lessor do so as well?

PwC response

Generally, yes. The lessee and the lessor apply the same basic classification criteria; however, differences in assumptions used to classify the lease (e.g., discount rate and the impact of renewal or purchase options) could give rise to classification differences. Lessor classification may also be impacted by factors unrelated to the lessee. For example, a lessor may obtain residual value insurance from a third party and include that guarantee in its lease payments. This could result in the lessor classifying the lease as a direct financing lease while the lessee classifies it as operating.

Furthermore, under the 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 3-3
Can the classification criteria be applied to a group of leased assets (i.e., a portfolio approach)?

PwC response

Yes. However, the results must not be materially different than classifying the underlying assets on an asset by asset basis. As a result, this approach would likely only be permitted in situations where the lease applies to a group of homogenous assets that have identical or nearly identical lease terms.

Question LG 3-4
Do the lease classification criteria in ASC 842-10-25-2 and ASC 842-10-25-3 apply to leases of land?

PwC response

Yes. Leases of land should be classified like any other lease; that is, evaluated based on the lease classification criteria in ASC 842-10-25-2 and ASC 842-10-25-3. Consequently, long-term leases of land may be classified as finance leases.

3.3.1 Transfer of ownership

A lease is classified as a finance lease by a lessee and as a sales-type lease by a lessor if ownership of the underlying asset transfers to the lessee by the end of the lease term. This criterion is also met if the lessee is required to pay a nominal fee for the legal transfer of ownership. However, if a lessee can choose not to pay the nominal fee (resulting in the lessee having the option not to purchase the underlying asset), the provision would not meet the transfer of ownership criterion because it would be considered an option to purchase the underlying asset. See LG 3.3.2 for information on the accounting for options to purchase the underlying asset.

It may be difficult to distinguish between a finance lease (subject to the guidance in ASC 842) and a financed purchase (sale) of an asset (subject to the guidance of ASC 606). Under ASC 606, the transfer of legal title to a buyer is an important indicator when determining whether an entity has transferred control of an asset to a customer, but that fact is not determinative in isolation. A question arises as to whether an arrangement should first be evaluated under ASC 606 or ASC 842. For example, since transfer of title does not automatically govern whether an entity has transferred control of an asset to a customer, it is not clear which standard should govern the accounting when title is not transferred to the customer at the beginning of the arrangement. Similarly, it is unclear which standard should govern when an arrangement does transfer legal title to the customer, but that transfer is not, in isolation, determinative as to whether a sale has occurred.

We believe that reporting entities should generally apply ASC 842, except when legal title transfers at the beginning of an arrangement. This may result in an entity classifying a lease as a sales-type (finance) lease, but, nevertheless, the transaction would be accounted for under ASC 842. Reporting entities should first apply the guidance in ASC 606 when legal title is transferred to the customer at the beginning of an arrangement. However, per ASC 606, an entity that transfers a good and retains a substantive forward repurchase obligations or call option (that is, a repurchase right) should not recognize revenue when the good is initially transferred to the customer because the repurchase right limits the customer’s ability to control the good. If the repurchase price is less than the original sales price of the asset and the arrangement is not part of a sale-leaseback transaction, the arrangement would be subject to the accounting and lease classification guidance under ASC 842.

3.3.2 Purchase options

If a lease contains an option to purchase the underlying asset and the option is reasonably certain to be exercised by the lessee, the lessee and lessor should classify the lease as a finance lease and a sales-type lease, respectively. An option may be reasonably certain to be exercised by the lessee when a significant economic incentive exists. For example, this may exist when the price of the option is favorable relative to the expected fair value of the underlying asset at the date the option becomes exercisable or when certain economic penalties exist that compel the lessee to elect to exercise its option. See LG 3.4 for additional information on the impact of economic factors on the application of the reasonably certain threshold.

3.3.2.1 Purchase option prices

A purchase option, whether fixed price or formula driven, should be evaluated to determine if it represents a significant economic incentive such that the lessee is reasonably certain to exercise it. Generally, an option to purchase a leased asset at a price greater than or equal to an asset’s fair value at lease commencement would not give rise to a significant economic incentive based on price. Additional consideration is required when a fixed-price option allows the lessee to buy the asset at a price that is less than the fair value of the asset at the lease commencement date. Both the lessee and lessor should consider all relevant factors, including the nature of the leased asset and the length of time before the option becomes exercisable, which may impact the likelihood that the lessee would exercise the option. For example, an option to purchase real estate at a price below the commencement date fair value is more likely to be considered reasonably certain of exercise than a similar option on equipment since real estate is generally expected to appreciate in value over the lease term whereas equipment is more likely to depreciate in value.

See LG 3.4 for additional information on the application of the reasonably certain threshold.

3.3.3 Lease term test

If the lease term is for a major part of the remaining economic life of the underlying asset, the lessee has effectively obtained control of the underlying asset and should classify the lease as a finance lease; the lessor should classify the lease as a sales-type lease. While ASC 842 does not require the use of bright lines, one approach to applying this indicator is to consider a lease term to be for a major part if it is equal to or greater than 75% of the underlying asset’s remaining economic life. As land has an indefinite life, this criterion would not apply to leases of land.

Leases that commence at or near the end of the underlying asset’s economic life are exempt from applying this particular lease classification criterion. When determining if a lease has commenced at or near the end of the underlying asset’s economic life, use to date and the remaining economic life of the underlying asset at lease commencement should be considered. The FASB has indicated that one reasonable approach to determining the applicability of this exception is to conclude that a lease that commences in the final 25% of an asset’s economic life is at or near the end of the underlying asset’s economic life. While there may be differing views in practice, we believe this exception should apply whenever entities are required to classify a lease, e.g., when a lease is modified and the modification is not accounted for as a separate lease. We believe that, for classification purposes, the “commencement date” for an existing lease that is modified is the date the modification is executed.

See LG 3.3.3.2 for additional information on determining the estimated economic life of a leased asset.

3.3.3.1 Determining the term of the lease

Leases often include options to either extend the term of the lease (commonly referred to as a “renewal option”) or to terminate the lease prior to the contractual lease expiration date (commonly referred to as a “termination option”).

As discussed in ASC 842-10-30-1, a lessee or lessor should consider all relevant contractual provisions, including renewal and termination options, to determine the term of the lease. Only renewal or termination options that are reasonably certain of exercise by the lessee should be included in the lease term. Additionally, if a renewal option is controlled by the lessor, the lessee and lessor must include that renewal period in determining the lease term.

ASC 842-10-30-1

An entity shall determine the lease term as the noncancellable period of the lease, together with all of the following:

Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.

Unlike a renewal option controlled by the lessor, periods covered by a renewal option controlled or effectively controlled by a third party may or may not be included in the lease term. Judgment must be applied to determine whether an option controlled or effectively controlled by a third party should be reflected in the lease term.

The assessment of whether it is reasonably certain that a lessee will exercise an option should be based on the facts and circumstances at lease commencement. The assessment should not be based solely on the lessee’s intentions, past practices, or estimates. It should focus on the factors that create an economic incentive for the lessee, including contract-, asset-, entity-, or market-based factors.

We believe that a lease that is cancellable only upon the occurrence of a remote contingency should be considered noncancellable for lease classification purposes.

If significant enough, a penalty for cancellation may result in a conclusion that continuation of the lease appears, at lease commencement, to be reasonably certain. If so, it should be considered noncancellable for any periods in which the penalty exists.

Question LG 3-5
How should a lessee consider its past practices in assessing whether it is reasonably certain to exercise an option to renew a lease or to purchase an underlying asset?

PwC response

A lessee should not rely solely on past practice, but should consider the economics underlying its negotiated arrangement. The FASB acknowledged that optional terms may not meet the conceptual definition of a liability, and therefore, the measurement of a lease liability should include options only when the lessee has economically little choice but to exercise the option. However, a lessee’s past practices (e.g., its history of retaining assets for a particular length of time before replacing them) may be in response to factors that would commercially compel the lessee to renew the lease or to exercise a purchase option.

To determine whether a renewal option is reasonably certain of exercise, a lessee and lessor should compare the renewal rents with the expected fair market rents for equivalent property under similar terms and conditions. In general, a renewal option with renewal rents that are equal to or greater than the rents in the initial lease term is not considered to be reasonably certain of exercise; however, this presumption could be overcome if the economic penalties the lessee would suffer by not exercising the renewal option are significant. Any step-down in rents in a renewal period should give rise to a presumption (which can be overcome) that the renewal option is reasonably certain of exercise by the lessee. See LG 3.4 for factors to consider when determining whether renewal, termination, or purchase options are reasonably certain of exercise.

Question LG 3-6
How should a lessee and lessor determine the lease term in an arrangement that has no explicit end date?

PwC response

A lessee and lessor should evaluate the enforceable rights and obligations in the contract. Any period that may not be cancelled by the lessee should be included. Additionally, any provisions that allow the lessee to extend the lease (i.e., renewal options) should be evaluated to determine whether the lessee is reasonably certain to exercise them. For example, a lease agreement may provide a lessee with the right to use an underlying asset on a daily basis (no stated end date) that the lessee may return at any point subsequent to the first day of use. The noncancellable period of this type of lease would be a single day and each subsequent day would be considered a daily renewal option that should be included in the lease term if determined to be reasonably certain of exercise by the lessee after considering all relevant contract-, asset-, entity-, and market-based factors.

Question LG 3-7
How should a lessee and lessor determine the lease term in an arrangement that can be canceled by either party?

PwC response

A lessee and lessor should first evaluate whether both parties have the unilateral right to terminate the arrangement (i.e., symmetrical termination rights). If termination rights are symmetrical, the lessee and lessor should determine if terminating the lease would result in either party incurring more than an insignificant penalty, as defined in ASC 842-10-20. If the termination rights are symmetrical with no more than an insignificant penalty, the lease term is limited to the period up to the time those symmetrical rights are exercisable. If termination rights are not symmetrical or either party would incur more than an insignificant economic penalty, the lessee and lessor should follow the framework discussed above.

When evaluating whether the lessee or lessor would incur more than an insignificant economic penalty, they should consider not only cash payments required to be made upon exercise of the termination options, but also other penalties, such as the cost of abandoning leasehold improvements or the disruption caused by relocating employees (see LG 3.4 for other examples of termination penalties). We believe arrangements such as these will be most prevalent in related party agreements. See LG 3.2 for other related party leasing considerations.

Question LG 3-8
Would a lease with a nonconsecutive term totaling 365 days or less be considered a short-term lease if the overall agreement spans a period more than 12 months?

PwC response

Yes. We believe the determination of short-term, as defined in ASC 842-10-20, should be evaluated on the basis of aggregate nonconsecutive periods. See LG 2.2.1 for information on the short-term lease measurement and recognition exemption.

Question LG 3-9
Is a lease with a fiscal funding clause (a clause included in some leases with federal, state, and local government that gives the lessee the right to cancel if funds are not appropriated in future years) considered noncancellable?

PwC response

Generally, yes. A fiscal funding clause should be evaluated to determine whether it is more than remote that a lessee will exercise the clause. If it is determined that a lessee’s exercise of a fiscal funding clause is more than remote, only the periods for which exercise is remote should be included in the lease term. In evaluating these provisions, the factors to be considered may include (1) a lessor’s experience relative to other similar leases with the same lessee and/or with similar lessees and governmental agencies, (2) technological obsolescence, and (3) whether the leased asset is essential to continued normal operation of the governmental unit.

Example LG 3-1, Example LG 3-2, Example LG 3-3, and Example LG 3-4 illustrate the effect of renewal options on the lease term.

EXAMPLE LG 3-1
Lease term – ground lease with a renewal option

Lessee Corp enters into a 15-year ground lease agreement. The lease grants Lessee Corp an option to renew the lease for an additional 15 years. The ground rents adjust to current market rates for equivalent unimproved land upon exercise of the renewal option.

Lessee Corp plans to construct a building on the leased land. The cost of the building is significant and its estimated life is 30 years.

What is the lease term?

Analysis

The lease term is 30 years. The loss of the building after year 15 as a result of non-renewal of the ground lease provides Lessee Corp a significant incentive to renew the ground lease for another 15 years.

EXAMPLE LG 3-2
Lease term – building lease with a renewal option

Lessee Corp enters into an agreement to lease an office building for 10 years. The lease grants Lessee Corp the option to renew the lease for an additional 10 years. The rental costs adjust to current market rents for equivalent office space upon exercise of the renewal option.

What is the lease term?

Analysis

Since the rents at the beginning of the renewal period will adjust to market rents, the renewal option does not create an economic incentive for Lessee Corp to exercise its option. Therefore, assuming the asset is neither unique nor specialized and no other economic incentives exist, Lessee Corp will likely conclude, at the lease commencement date, that the option is not reasonably certain of exercise. Accordingly, the lease term would be 10 years.

EXAMPLE LG 3-3
Lease term – third party is not reasonably certain to exercise a renewal option

Lessee Corp leases an asset for a 10-year noncancellable period with two 5-year renewal options (the “head lease”) from Lessor Corp. Lessee Corp subleases the leased asset to Sublessee also for a noncancellable period of 10 years with two 5-year renewal options. Lessee Corp (as sublessor) determines Sublessee is not reasonably certain to exercise its options to extend the sublease. Lessee Corp also determines it is not reasonably certain that it will exercise any renewal options in the head lease.

How should Lessee Corp (as sublessor) determine the term of the head lease, considering the renewal options held by Sublessee?

Analysis

Including optional renewal periods could impact both classification and measurement of Lessee Corp’s lease of the asset. The guidance in ASC 842-10-30-1 (see LG 3.3.3.1 above) states that the lease term includes “periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.”

One might infer that this guidance requires the lessee to include all optional periods it must exercise due to circumstances outside the lessee’s control (e.g., a renewal right over the asset granted by the Lessee to Sublessee). However, Lessee Corp is not required to include the renewal periods in the lease term merely because Sublessee holds renewal rights. Instead, Lessee Corp must assess whether non-renewal by Sublessee imposes an economic penalty sufficient to provide a significant economic incentive for Sublessee to exercise its renewal options. If so, the optional renewal periods would be included in lease term by Lessee Corp in evaluating its lease and sublease. If not, Lessee Corp would classify and measure its lease based on the noncancellable lease term.

In this example, the term of the head lease would be 10 years because (1) Lessor Corp cannot control whether Lessee Corp will exercise the extension option and (2) Lessee Corp concluded it is not reasonably certain that it will exercise any renewal options in the head lease.

Reassessing lease term

Subsequent to lease commencement, Lessee Corp would follow reassessment guidance for lessors to evaluate changes occurring during the sublease term (see LG 5.7). In accordance with lessor guidance on reassessment, Lessee Corp (as sublessor) would not reassess whether Sublessee is reasonably certain to renew the sublease until Sublessee actually exercises a renewal option not already included in the lease term. Until then, Lessee Corp would also not reassess the term of the head lease for the actions of Sublessee (e.g., if Sublessee began installing leasehold improvements, indicating it is likely to exercise a renewal option) as those actions are outside of Lessee Corp’s control. Lessee Corp would follow reassessment guidance applicable to lessees to evaluate changes, including those resulting from triggering events that are within its own control occurring during the head lease term (see LG 5.3.1).

EXAMPLE LG 3-4
Lease term –third party is reasonably certain to exercise a renewal option

Lessee Corp leases an asset for a 10-year noncancellable period with two 5-year renewal options (the “head lease”) from Lessor Corp. Lessee Corp subleases the leased asset to Sublessee also for a noncancellable period of 10 years with two 5-year renewal options. At lease commencement, Lessee Corp (as sublessor) determines Sublessee is reasonably certain to exercise its options to extend the sublease.

How should Lessee Corp (as sublessor) determine the term of the head lease?

Analysis

The term of the head lease would be 20 years because Lessee Corp (as sublessor) concluded Sublessee is reasonably certain to exercise its options to extend the sublease. Lessee Corp’s obligation to supply the asset as sublessor results in Lessee Corp similarly concluding the renewal options in the head lease are reasonably certain of exercise.

We believe the same conclusion would be reached if the asset were specialized and, instead of subleasing the asset, Lessee Corp intended to use the asset to fulfill a revenue contract with a third party. That is, Lessee Corp must evaluate whether or not it is reasonably certain that it will use the asset to fulfill the revenue contract during the renewal periods.

Example LG 3-5 illustrates how to determine a lease term for lease portfolios where a lessee can terminate a percentage of the individual leases early.

EXAMPLE LG 3-5
Lease term –Lease portfolios where a lessee can terminate a percentage of the individual leases early

Lessee Corp. leases a portfolio of 100 automobiles from Lessor Corp. Each automobile can be used and operated independent of the other automobiles. Therefore, the arrangement is considered leases of multiple assets. The lease term is three years; however, Lessee Corp has the option to return 40 of the automobiles after 2 years. Lessee Corp. believes that it is reasonably certain that it will return 40 automobiles after 2 years.

The automobiles are similar and there is no higher likelihood that any individual automobile will be returned early. In other words, it is 60% likely that each automobile will be kept for the full lease term and conversely it is 40% likely that each automobile will be returned early.

What lease term should be used for each automobile?

Analysis

Lessee Co. should use a three- year lease term for 60 of the automobiles and a two-year lease term for 40 of the automobiles. Lessor Corp. should use the same lease terms.

3.3.3.2 Determining the estimated economic life

The ASC 842 Glossary provides the following definition of economic life.

Definition from ASC 842 Glossary

Economic Life: Either 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.

Determining the estimated economic life of an underlying asset may be similar to establishing the depreciable life of an asset. Depreciable lives may therefore provide a starting point to estimate economic lives for comparable assets. Whether an asset is owned or rented should not affect the length of its economic life.

Determining the estimated economic life of a new asset may be easier than determining the estimated economic life of equipment that has previously been owned or leased. A lessor or lessee should consider the remaining life of the underlying asset at lease commencement.

Example LG 3-6 and Example LG 3-7 illustrate how to determine the estimated economic life.

EXAMPLE LG 3-6
Estimated economic life – economic life of a new asset (manufacturing equipment)

Lessee Corp is in the business of manufacturing electrical devices for sale in retail hardware stores. Lessee Corp normally purchases equipment used in its manufacturing process from a third-party original equipment manufacturer (OEM) and assigns a 15-year useful life to the manufacturing equipment. Similar equipment must be replaced after 15 to 20 years of use (assuming normal repairs and maintenance during the usage period), after which it is typically scrapped.

In an effort to manage cash flows, Lessee Corp enters into a 10-year arrangement with the OEM to lease a new piece of manufacturing equipment. The new equipment is similar in nature to the equipment Lessee Corp normally purchases; if Lessee Corp were purchasing the equipment outright, it would assign a 15-year useful life for depreciation purposes.

What is the estimated economic life of the equipment for purposes of classifying the lease?

Analysis

Since the manufacturing equipment needs to be replaced at some point between 15 and 20 years, the estimated economic life should fall within that range. The midpoint of the range (i.e., 17.5 years) may be a reasonable estimate of the equipment’s economic life assuming a more precise method of estimating the underlying asset’s economic life does not exist.

EXAMPLE LG 3-7
Estimated economic life – economic life of a used asset (real estate)

Lessee Corp enters into a 10-year lease with Lessor Corp for the use of a warehouse. The warehouse is 40 years old at lease commencement. Lessee Corp has purchased other warehouses and typically depreciates them over 40 years.

What is the estimated economic life for purposes of classifying the lease?

Analysis

If Lessee Corp simply looks to the age of the warehouse, it may conclude that the building has no further economic life. However, this is not a reasonable assumption at lease commencement given Lessee Corp’s intent to lease the building for 10 years.

The remaining economic life of the building should be estimated based on its condition at lease commencement and Lessee Corp’s estimate of how long the building will be usable in the future assuming normal repairs and maintenance. The assessment should be based on the underlying asset, not the lease term. Lessee Corp may conclude that the building has a future economic life in excess of the 10-year lease term depending on the building’s condition.

When classifying a lease, a lessor similarly should consider the remaining economic life of the underlying asset considering its condition, even if that life exceeds the useful life over which it depreciates the asset.

3.3.3.3 Economic life involving multiple assets

As discussed in ASC 842-10-25-5, a reporting entity should determine which asset represents the predominant asset when a lease component contains multiple underlying assets. Only the remaining estimated economic life of the predominant asset should be considered when classifying the lease component.

Example 13 in ASC 842-10-55-146 through ASC 842-10-55-149 illustrates the application of this guidance to a lease of a turbine plant. The leased turbine plant consists of the turbine, the building that houses the turbine, and the land under the building. The example concludes that these assets collectively represent a single lease component. Considering the lessee entered into the lease to obtain the power-generation capabilities of the turbine, and the land and building would have little to no use or value to the lessee without the turbine, the turbine represents the predominant asset in the lease component. Accordingly, the remaining economic life of the turbine should be used when evaluating the classification of the lease component.

3.3.4 Lease payment tests

This criterion (commonly referred to as the “lease payments criterion”) is met if the present value of the sum of lease payments and any residual value guaranteed by the lessee that has not already been included in lease payments in accordance with ASC 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset. Although the FASB did not include bright lines in ASC 842, it has indicated that one approach to applying this indicator is to consider payments equal to or greater than 90% of the underlying asset’s fair value.

ASC 842-10-30-5 lists the six types of lease payments to be included in the measurement of aggregate lease payments used for lease classification purposes.

ASC 842-10-30-5

At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term:

Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31).
Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date.
The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option (assessed considering the factors in paragraph 842-10-55-26).
Payments for penalties for terminating the lease if the lease term (as determined in accordance with paragraph 842-10-30-1) reflects the lessee exercising an option to terminate the lease.
Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph 842-10-25-2(d).
For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36).

If a lease includes nonlease components, their values and associated payments should be separated and excluded for purposes of lease classification, unless a lessee makes an accounting policy election not to separate nonlease components for the particular asset class. See LG 2.4 for information on multiple element arrangements and the allocation of consideration to lease and nonlease components.

Question LG 3-10
Are the costs associated with removing leasehold improvements installed by the lessee (i.e., a lessee’s obligation to return an underlying asset to its original condition) considered lease payments?

PwC response

No. The costs associated with a lessee’s obligation to return an underlying asset to its original condition generally would not meet the definition of a lease payment (defined in ASC 842-10-30-5), and should not be included when assessing lease classification or in the measurement of the lessee’s lease liability. Since the costs are associated with removing the lessee’s owned assets, these costs should be accounted for using the guidance in ASC 410, Asset Retirement and Environmental Obligations.

Question LG 3-11
Are the costs a lessee incurs to dismantle and remove the lessor’s underlying asset at the end of the lease term considered lease payments?

PwC response

These payments are incurred by the lessee to remove the lessor’s assets and consequently they would be subject to the guidance in ASC 842 (not ASC 410). However, these costs meet the definition of variable lease payments under ASC 842 because the ultimate amount payable will vary based on changes in factors after lease commencement. Because the payments are not based on an index or rate, they should not be included as a lease payment when assessing classification or in the measurement of the lessee’s lease liability.

Question LG 3-12
Should lease payments include nonmonetary consideration (e.g., common stock of a lessee)?

PwC response

Generally, yes. We believe noncash consideration should be included in lease payments, measured at fair value on the lease commencement date. However, there are certain forms of noncash consideration that are explicitly excluded from lease payments, such as a lessee’s guarantee of a lessor’s debt.

Question LG 3-13
Should lease payments include deposits paid by a lessee to a lessor?

PwC response

It depends. Provisions in a lease agreement commonly require a lessee to pay a deposit to a lessor at or before the lease commencement date to financially protect the lessor in the event the lessee damages or does not properly maintain the underlying asset. If the asset is not damaged and is properly maintained, the lessor is required to reimburse the lessee for the full amount of the deposit at the end of the lease.

If a deposit paid by a lessee to a lessor is refundable, we do not believe the deposit is a lease payment. Rather, the payment should be accounted for as a deposit asset and liability by a lessee and lessor, respectively. Deposits should be evaluated to determine whether it is probable all or a portion of the deposit will be returned to the lessee at or before the end of the lease term. When an amount on deposit is less than probable of being returned to the lessee, it should be recognized in the same manner as a variable lease payment (i.e., a period cost).

If a deposit paid by a lessee to a lessor is nonrefundable, we believe the deposit is a lease payment. For example, if a lessee is required to pay a lessor a deposit at or before the lease commencement date to demonstrate its commitment to lease the underlying asset, the deposit should be accounted for as a fixed lease payment.

Question LG 3-14
Should a lessor account for sales tax and other similar taxes collected from a lessee as contract consideration?

PwC response

It depends. As an accounting policy election, a lessor may account for sales tax and other similar taxes collected from a lessee as lessee costs. If this policy is elected, a lessor would exclude these costs from contract consideration and variable consideration and present revenue net of these costs. If elected, adequate disclosure of the policy election is required. This policy election cannot be applied to a lessor’s gross receipts taxes.

Question LG 3-15
How should a lessor account for costs that are explicitly required to be paid by a lessee on the lessors’ behalf?

PwC response

It depends. A lessor should exclude from variable payments all lessor costs that are explicitly required to be paid directly by a lessee on behalf of the lessor to a third party. Examples include property taxes and insurance. A lessor would report revenue net of these amounts. Costs that are not part of contract consideration that are paid by a lessor to a third party and reimbursed by the lessee are considered lessor costs and would be accounted for as variable payments by the lessee. The lessor would therefore report these amounts gross on the income statement. ASC 842-10-15-40A only relate to costs associated with the lease, and not lease payments themselves.

Question LG 3-16
Are payments related to non-performance-related default covenants considered lease payments for lease classification purposes?

PwC response

No, any payments that must be made as a result of non-performance are not considered when assessing lease classification. These payments are considered variable lease payments.

3.3.4.1 Fixed lease payments

Fixed lease payments are payments required under the lease. They can be either a fixed amount paid at various intervals in a lease (e.g., a five-year equipment lease with annual lease payments of $2,000) or they can be payments that change over time at known amounts (e.g., lease payments of $2,000 per month at lease commencement that increase annually by $250 per month).

The exercise price of a purchase option should be included in the calculation of lease payments for purposes of lease classification and measurement when exercise is reasonably certain. See LG 3.4 for information on the application of the reasonably certain threshold.

ASC 842-10-30-5 requires lease incentives to be recorded as a reduction of fixed payments when determining lease payments. See LG 3.3.4.2 for information on lease incentives.

Example LG 3-8 illustrates how to determine the fixed lease payments.

EXAMPLE LG 3-8
Lease payments – determining the fixed payments

Lessee Corp and Lessor Corp enter into a 10-year lease of an office building for fixed annual lease payments of $100,000. Per the terms of the lease agreement, annual fixed lease payments to Lessor Corp comprise $85,000 for rent and $15,000 for real estate taxes.

What are the fixed lease payments for purposes of classifying the lease?

Analysis

The fixed lease payments are $100,000. Although real estate taxes are explicitly stated in the lease contract, they do not represent a separate nonlease component as they do not provide a separate good or service. The right to use the office building is the only component. The annual lease payments of $100,000 represent payments related to that single lease component.

See Example LG 3-9 for information on variable payments for real estate taxes. See LG 2.4 for additional information on identifying lease and nonlease components in a contract.

Leasehold improvements

Payments made by lessees for improvements to the underlying asset (e.g., upgrades to lighting, flooring, pantries) should be recorded as prepaid rent and included in fixed lease payments if the payment relates to an asset of the lessor. Determining whether payments made by a lessee for improvements to the underlying asset should be accounted for as lease payments to a lessor or as leasehold improvements of the lessee requires judgment. There is diversity in practice and there are a number of models in use to make the determination. While other models may be acceptable, we believe the following model closely follows the economics.

Generally, if a lease does not specifically require a lessee to make an improvement, the improvement should be considered an asset of the lessee. Payments for lessee assets should be excluded from lease payments when evaluating lease classification and measuring the right-of-use asset and lease liability. However, if the lease requires the lessee to make an improvement, the uniqueness of the improvement to the lessee’s intended use should be considered. Improvements that are not specialized and for which it is probable they could be utilized by a subsequent tenant would likely be considered assets of the lessor. Other factors to consider include whether the improvement increases the fair value of the underlying asset from the standpoint of the lessor and the economic life of the improvement relative to the lease term.

If a lessee is required to complete a lessor asset improvement, but the improvement has not been completed as of the lease commencement date, an estimate of the costs to construct the asset, net of any funding to be provided by the lessor, should be included in lease payments for purposes of classification and measurement. Any subsequent difference between the estimated and actual cost of the improvement should be accounted for as variable lease payments. See LG 3.3.4.3.

See LG 3.3.4.2 for information on lessor reimbursement for leasehold improvements.

3.3.4.2 Lease incentives

As discussed in ASC 842-10-55-30, a lease agreement may include incentives to encourage a lessee to sign the lease, such as an up-front cash payment to a lessee, payment of lessee costs (such as moving expenses), or the assumption by a lessor of a lessee’s preexisting lease. When a lessor assumes a lessee’s preexisting lease with a third party, the lessee and lessor should independently estimate any loss associated with the assumption as illustrated in ASC 842-10-55-30(b).

Excerpt from ASC 842-10-55-30(b)

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 of use of the assumed underlying asset.

Like other amounts included in lease payments, lease incentives are included in the calculation of consideration in the contract, which must be allocated when multiple components exist (e.g., lease and nonlease components). However, irrespective of the allocation, lease incentives always reduce the consideration in the contract for a lessee and lessor.

For a lessee, the reduction to fixed lease payments will affect lease classification and the initial measurement of the right-of-use asset and lease liability. For a lessor, the reduction will affect lease classification and the measurement of lease income on a straight-line basis (if classified as an operating lease) or the net investment in the lease (if classified as a sales-type or direct financing lease).

Reimbursement for leasehold improvements

Lessor reimbursement for some (or all) of the costs a lessee incurs to complete leasehold improvements is a common example of a lease incentive. These payments may be calculated as a certain amount per square foot or a fixed amount regardless of the level of improvements undertaken by a lessee.

To determine whether a payment from the lessor to the lessee represents a lease incentive, a reporting entity must determine whether it represents a lessee or a lessor asset. See LG 3.3.4.1 for additional information about making that determination. If an improvement represents a lessee asset, the lessor payment is a lease incentive that should be recorded as a reduction to fixed lease payments. On the other hand, when a lessee pays for an improvement that is a lessor asset, the expenditure is prepaid rent rather than a lease incentive; the reimbursement is a reduction to prepaid rent. If a lessee was not fully reimbursed, the difference between the costs incurred and the reimbursements received would be included in lease payments.

If a lessor agrees to pay a fixed or formula-based amount to the lessee once the lessee provides evidence of the expenditures and the contract does not specify the nature of the improvements to be completed, it is reasonable to conclude that the improvements represent lessee assets. However, if the amount a lessee will receive is based on the actual costs incurred on improvements that are specified in the contract, judgment will be required to determine whether the improvements represent lessee or lessor assets.

When lessor reimbursement for lessee assets (i.e., a lease incentive) occurs subsequent to lease commencement, the lessee and lessor must determine whether the lease incentive is considered fixed or variable. If the incentive is subject to a cap and it is reasonably certain the lessee will use some or all of the amount available for reimbursement by the lessor, we believe the portion of the incentive that is reasonably certain of use should be treated as an in substance fixed lease payment (i.e., reduction to lease payments). A leasehold improvement allowance that is negotiated between a lessee and lessor creates an economic incentive for the lessee to use the full amount of the allowance. Therefore, negotiated lease incentives are generally considered reasonably certain of use because a lessee is economically incentivized to use the entire incentive that it negotiated.

For lessees, at lease commencement, if an allowance for lessee assets represents an in substance fixed lease payment, we believe a lessee should estimate the timing and amount of the payments not yet received and include them in lease payments when classifying the lease and measuring the lease liability, which in turn would get reflected in the right-of-use asset. See LG 3.3.4.3 for further discussion on in substance fixed lease payments.

Similarly, a lessor should estimate the timing and amount of the payments not yet paid when classifying the lease and measuring the net investment in the lease if classified as a sales-type or direct finance lease. If classified as an operating lease, although there is no impact to any amounts recorded at lease commencement, the reduction to lease payments is included in the calculation of lease income that will be recorded on a straight-line basis over the lease term.

See LG 5.3.2 for information on the subsequent accounting for estimated lease incentives.

If an incentive is determined to be variable at lease commencement, we believe a lessee should account for the lease incentive as variable rent when the contingency is resolved. Therefore, the incentive does not impact lease classification or initial measurement of the lease liability.

Question LG 3-17
How should a lessee account for in substance fixed lease incentives that will be used to construct lessee assets when all other lease payments are entirely variable?

PwC response

We believe that at lease commencement, the lessee must measure the lease liability and right-of-use asset in accordance with ASC 842-20-30-1. Because the lease payments (other than the incentive) are entirely variable, this would result in the recognition of a receivable rather than a liability. This would also result in a negative right-of-use asset (prior to considering the impact of any prepaid rents or initial direct costs), which would be classified as a liability. The liability would then be amortized on a straight-line basis over the lease term as a reduction to rent expense.

3.3.4.3 Variable lease payments

Variable lease payments, or contingent payments, are defined in the ASC 842 Glossary and further discussed in the Basis for Conclusions in ASU 2016-02.

Definition from ASC 842 Glossary

Variable Lease Payments: Payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.

ASU 2016-02 BC205

Some or all of the lease payments for the right to use an asset can be variable. That variability can arise because lease payments are linked to:

Price changes due to changes in an external market rate or the value of an index. For example, lease payments might be adjusted for changes in a benchmark interest rate or the Consumer Price Index.
The lessee’s performance derived from the underlying asset. For example, a lease of retail property may specify that lease payments are based on a specified percentage of sales made from that property.
The use of the underlying asset. For example, a car lease may require the lessee to make additional lease payments if the lessee exceeds a specified mileage.

Variable lease payments that depend on an index or a rate should be included in the calculation of lease payments when classifying a lease and in the measurement of the lease liability. Variable lease payments should be calculated at lease commencement, using the index or rate at lease commencement; no increases or decreases to future lease payments during the lease term should be assumed.

Variable lease payments other than those that depend on an index or a rate should not be included in lease payments for purposes of classification and measurement of the lease, unless those payments are in substance fixed lease payments.

If a lease includes a renewal option that the lessee is reasonably certain to exercise and the payments during the renewal period are based on the fair market rents at the beginning of the renewal period, we believe the renewal period rents should be treated similar to variable lease payments that depend on an index or rate. This approach is consistent with IFRS 16.28, which says that variable lease payments that depend on an index or rate include payments that vary to reflect changes in market rental rates.

Subsequent to the lease commencement date, when the actual payments in the renewal period are known, the lessee would not remeasure the lease payments. Rather, any changes would be a period cost during the period in which they are incurred. The lessor would record the changes as earned during the period they occur.

See LG 5.3.1 for information on when to remeasure lease payments, including the impact of variable lease payments on remeasurement.

Example LG 3-9, Example LG 3-10, and Example LG 3-11 illustrate when to include variable lease payments in the calculation of lease payments when classifying a lease.

EXAMPLE LG 3-9
Lease payments – variable lease payments tied to an index

Lessee Corp enters into an agreement with Lessor Corp to lease office space for a term of 60 months. Lease payments during year one of the lease are $10,000 per month. Each year, lease payments increase by an amount equivalent to the percentage increase in the Consumer Price Index (CPI). For example, if the CPI increases by 3%, lease payments during year two of the lease would increase 3% to $10,300 per month. If the CPI decreases or remains consistent, lease payments remain at the rate in effect during the previous year.

What are the lease payments for purposes of classifying the lease?

Analysis

Increases in lease payments are tied to the percentage change in the CPI and movements in the CPI subsequent to lease commencement are unknown. As such, only the initial lease payments of $10,000 per month would be included in the calculation of lease payments when classifying the lease.

See Example LG 4-6 for an example of the initial measurement of a lease with a variable lease payment tied to an index.

EXAMPLE LG 3-10
Lease payments – variable lease payments tied to real estate taxes

Lessee Corp and Lessor Corp enter into a 10-year lease of an office building for fixed annual lease payments of $85,000. Per the terms of the lease agreement, Lessee Corp is required to pay Lessor Corp an amount equal to all real estate taxes associated with the building during the lease term. Real estate taxes are expected to be $15,000 for the first year of the lease.

What are the lease payments for purposes of classifying the lease?

Analysis

The lease payments are $85,000. Although the terms of the lease require Lessee Corp to pay Lessor Corp an amount equal to the real estate taxes, real estate taxes vary on an annual basis. As such, they would be considered variable lease payments that are not dependent on an index or a rate. As a result, they should be excluded from lease payments for purposes of classification and measurement.

As discussed in Example LG 3-8, real estate taxes do not represent a separate lease component. See LG 2.4 for additional information on identifying lease and nonlease components.

EXAMPLE LG 3-11
Lease payments – variable lease payments tied to fair market value

Lessee Corp enters into a five-year noncancellable office lease with Lessor Corp. The lease contains a 5-year renewal option that Lessee Corp is reasonably certain to exercise. The lease payments are fixed at $600k annually for each of the first five years. The annual lease payments for the renewal option will be set at the beginning of the renewal period based upon the fair market rent at the beginning of the renewal period.

Should the lease liability include amounts related to the renewal period even though the amount of the annual lease payments for that period is unknown at the lease commencement date?

Analysis

Yes. Similar to variable lease payments that depend on an index or rate, lease payments during the renewal period should be included in lease payments when classifying and measuring the lease at lease commencement. The renewal period rents should be based on the market rental rate at lease commencement (i.e., $600k per year), not the estimated market rental rate at the beginning of the renewal period.

In substance fixed lease payments

Variable lease payments that are considered in substance fixed lease payments should be included in the calculation of lease payments for classification and measurement. ASC 842-10-55-31 provides guidance on in substance fixed lease payments.

Excerpt from ASC 842-10-55-31

In substance fixed payments are payments that may, in form, appear to contain variability but are, in effect, unavoidable. In substance fixed payments for a lessee or a lessor may include, for example, any of the following:

Payments that do not create genuine variability (such as those that result from clauses that do not have economic substance)
The lower of the payments to be made when a lessee has a choice about which set of payments it makes, although it must make at least one set of payments.

Variable lease payments based on performance or use are excluded from the calculation of lease payments for classification and measurement. This is true even if there is a high probability of some payment for usage during the lease term. Accordingly, a reporting entity would not include payments that vary solely on the basis of future use or performance in lease payments, regardless of the probability of occurrence (except in cases where the arrangement contains a guaranteed minimum payment or penalty that effectively amounts to a floor for lease payments).

Some lease payments are contingent in form, but are in effect, unavoidable; for example, payments due to clauses that lack economic substance or that provide a choice of payment type, but no ability to avoid a payment.

For example, consider a 10-year lease that provides for an increase in rent beginning in year six, which is calculated as five times the change in the CPI over the prior five-year period, with any increase in rent capped at 5%. It is reasonable to conclude a 5% rent increase commencing in the sixth year of the lease term is unavoidable; therefore, the 5% rent increase should be included in lease payments by the lessee and lessor.

There is often some portion of a contingent lease payment that is highly probable of being paid (e.g., some level of payment will generally be required in a lease that provides for percentage rent based on sales derived from the output of the leased asset). However, because the payment provision creates genuine variability, the total payment should be considered a variable lease payment and excluded from the lease payments.

A lease may include protective rights that impact the amount of lease payments due. Protective rights are generally rights that protect a lessee from the requirement to make payments during periods when the underlying asset is not available for use. For example, lease payments due may be substantially reduced during periods of excessive downtime for maintenance or inspection, when a lessor defaults on its obligations, or when weather conditions render the underlying asset unavailable to the lessee. The effect of protective rights should be disregarded when determining lease payments for purposes of classification and measurement.

Example LG 3-12, Example LG 3-13, Example LG 3-14, and Example LG 3-15 illustrate how to determine if variable lease payments are considered in substance fixed lease payments.

EXAMPLE LG 3-12
Lease payments – payments tied to sales

Lessee Corp enters into a 10-year lease for retail office space with Lessor Corp. The annual lease payments are $20,000 plus an amount equal to 5% of Lessee Corp’s sales. Lessee Corp’s annual sales have exceeded $200,000 since it began operations and are projected to grow at a rate of 10% annually.

What are the lease payments for purposes of classifying the lease?

Analysis

The lease payments for purposes of classifying the lease are the fixed annual lease payments of $20,000.

Although there is a high probability of some variable lease payments being made in light of Lessee Corp’s historical results and projections, the variable lease payments are based exclusively on, and vary with, the performance of the underlying asset and do not represent in substance fixed lease payments.

EXAMPLE LG 3-13
Lease payments – in substance fixed lease payments

Lessee Corp enters into a five-year lease for office space with Lessor Corp. The initial base rent is $10,000 per month. Rents increase by the greater of 1% of Lessee Corp’s generated sales or 3% of the previous rental rate on each anniversary of the lease commencement date.

What are the lease payments for purposes of classifying the lease?

Analysis

The lease payments for purposes of classifying the lease are the fixed monthly payments of $10,000 plus the minimum annual increase of 3%.

Lessee Corp is required to pay no less than a 3% increase regardless of the level of sales activity; therefore, this minimum level of increase is an in substance fixed lease payment.

EXAMPLE LG 3-14
Lease payments – payments tied to use of medical device consumables

Lessee Corp enters into a three-year lease for a medical device with Lessor Corp. Annual fixed lease payments are $100,000. Lessee Corp is also required to purchase at least $1 million of consumables to be used in the operation of the medical device by the end of the lease term. If Lessee Corp does not order $1 million of consumables, it is required to make a shortfall payment equal to the difference between the total consumables purchased and $1 million.

The measurement and allocation of contract consideration are not addressed in this example. For simplicity, assume all payments are allocated to the lease component (i.e., the medical device).

What are the lease payments for purposes of classifying the lease?

Analysis

The lease payments for purposes of classifying the lease include both the $300,000 fixed lease payments (3 years × $100,000 per year) and the in substance fixed lease payment of $1 million for consumables.

Although the payment for consumables varies based on use, because Lessee Corp is required to make payments of at least $1.3 million regardless of its consumable use, the $1 million minimum payment is an in substance fixed lease payment.

See Question LG 3-18 for information on the differences between payments included in lease payments and payments included in contract consideration. See LG 2.4 for information on measuring and allocating contract consideration to identified lease and nonlease components.

EXAMPLE LG 3-15
Lease payments – protective rights

Lessee Corp enters into a 5-year lease for equipment with Lessor Corp. The arrangement provides that Lessor Corp will maintain the equipment and operate it in accordance with instructions provided by Lessee Corp.

Payments due from Lessee Corp to Lessor Corp are based on the daily operation of the equipment (i.e., performance-based rates assigned to the nature of the activities performed each day throughout the term of the contract) as follows:

Each day the equipment is available for use and operated by Lessor Corp, Lessee Corp must pay $1,000;
Each day the equipment is available for use and Lessor Corp is available to operate the equipment, but the asset is not utilized as instructed by Lessee Corp, Lessee Corp must pay $750;
Each day the equipment is (a) unavailable for use at the request of Lessor Corp (e.g., maintenance, required inspections), (b) unavailable for use due to events outside of both Lessee Corp and Lessor Corp’s control (e.g., weather conditions), or (c) available for use, but Lessor Corp is not available to operate the equipment, Lessee Corp must pay $500. If the aggregate days the equipment is not operational due to (a), (b), or (c) exceeds 15 in a year, no payment is due from Lessee Corp for non-operational days exceeding the 15 day maximum. Based on historical experience with similar contracts, it is probable the total number of nonoperational days will exceed the 15 day maximum.

What are the lease payments for purposes of classifying the lease?

Analysis

Daily fixed payments are $750.

The daily rate of $750 represents the lowest amount the lessee would pay the lessor when the underlying asset is available for use. The additional $250 the lessee would pay when it uses the asset is a variable payment based on usage, and, therefore, is excluded from lease payments. The $500 payment level (and $0 payment) only apply when the lessor is unable to make the asset available for the lessees use, i.e., they result from a protective right. Payments (or payment reductions) resulting from a protective right are not considered in determining lease payments. Thus, any reductions in rent below $750 are (negative) variable payments. Variable payments are excluded from lease payments even though Lessee Corp and Lessor Corp concluded it is probable that the total number of nonoperational days will exceed the 15 day maximum, resulting in days when Lessee Corp is not required to make payments to Lessor Corp.

The daily rate of $750 represents the lowest contractual rate that is not the result of a protective right (i.e., it is the in substance daily fixed payment). Accordingly, the total annual consideration in the contract is $273,750 ($750 per day × 365 days), which should be allocated between the lease and nonlease components. Only the payments allocated to the lease should be considered for purposes of classifying the lease.

3.3.4.4 Residual value guarantees

The ASC 842 Glossary provides the following definition of a residual value guarantee.

Definition from ASC 842 Glossary

Residual Value Guarantee: A guarantee made to a lessor that the value of an underlying asset returned to the lessor at the end of a lease will be at least a specified amount.

A residual value guarantee provides a lessor with certainty (subject to credit risk) that the fair value of the underlying asset subject to lease will not decline below a certain amount. Lessees may be motivated to provide such guarantees in order to obtain a lease that may not otherwise be available to them or to obtain more favorable pricing for the leased asset. Lessors may also secure residual value guarantees from a third party to reduce or eliminate their risk in the residual value of the asset.

Residual value guarantees provided by a lessee

If the present value of the lease payments and any residual value guarantees provided by the lessee guarantees a lessor the recovery of substantially all of the fair value of its underlying asset, the arrangement is a finance lease for the lessee and sales-type lease for the lessor.

Lessees and lessors should include the full amount of the potential payment payable under a residual value guarantee in fixed lease payments when evaluating lease classification under ASC 842-10-25-2 (d) (i.e., the lease payments criterion). While the terms of certain residual value guarantees may eliminate virtually all of the lessor’s risk in the underlying asset, the likelihood of loss by the lessor is not a factor that should be considered when classifying a lease.

The requirement to include the full amount of the potential payment payable under a residual value guarantee differs from the measurement guidance, which requires that lessees and lessors consider only the present value of any payment under a lessee residual value guarantee that is probable of being owed.

A lessee may choose to obtain residual value insurance from an unrelated third party to protect against any exposure created by the provision of a residual value guarantee to a lessor. For example, if the residual value of the underlying asset was lower than the guaranteed amount at the end of a lease, the third party would make the necessary payments to satisfy the lessee’s residual value guarantee to the lessor. When third-party insurance is for the benefit of the lessor, a lessee may not reduce lease payments when measuring the lease unless the lessor explicitly releases the lessee from their obligation under the residual value guarantee, including any obligation should the third party default. Additionally, any payments by a lessee to acquire third party residual value insurance are executory costs, which should not be included in lease payments.

If a lease contains a provision that provides the lessor with the right to require the lessee to purchase the underlying asset by the end of the lease term, the stated purchase price should be included in lease payments. This is because the purchase price is effectively a residual value guarantee that the lessee is required to pay (i.e., the payment of the purchase price is outside of the lessee’s control). See Question LG 3-18 for further discussion.

Question LG 3-18
Should a lessee consider a residual value guarantee in the lease classification determination differently than how it considers the guarantee when measuring its lease liability?

PwC response

Yes. The probability of having to satisfy a residual value guarantee is not considered for purposes of lease classification, but is considered when measuring a lease liability. To illustrate, a lessee may provide a guarantee that the leased property will have a value that is no less than $100 at the end of the lease. The lessee believes it is probable it will owe $15 under this guarantee. In such a situation, it would include the present value of the full residual value guarantee amount (i.e., $100) when determining how to classify the lease, but it would include only the present value of the amount it is probable of owing (i.e., $15) when measuring its lease liability.

Residual value guarantees obtained from a third party

If a residual value guarantee is provided by a third party unrelated to the lessor, and none of the other criteria in ASC 842-10-25-2 are met, the lessor should evaluate whether the lease should be classified as a direct financing lease. A lessor would classify a lease as a direct financing lease if the lease meets both of the criteria in ASC 842-10-25-3(b).

ASC 842-10-25-3

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

A lessee shall classify the lease as an operating lease.
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.

For a lease to be classified as a direct financing lease, the lease payments and any amount necessary to satisfy a residual value guarantee should be probable of collection at lease commencement. If the lessor determines collection is not probable, the lease should be classified as an operating lease. See LG 3.3.4.7 for information on collectibility.

Example LG 3-16 illustrates the effect of a residual value guarantee on lease classification.

EXAMPLE LG 3-16
Residual value guarantee – third party

Lessor Corp enters into a lease of non-specialized construction equipment with Lessee Corp. The fair value of the equipment at lease commencement is $500,000. Lessee Corp does not provide a residual value guarantee.

Lessor Corp estimates that the fair value of the construction equipment at the end of the lease will be
$150,000. While Lessor Corp acknowledges the value of the asset may decline below $150,000 in the future, Lessor Corp concludes there is less than a 1% chance of the value falling below $100,000. Therefore, to protect its investment, Lessor Corp obtains residual value insurance from a third party covering any loss incurred by Lessor Corp if the value declines to between $150,000 to $100,000. That is, if the residual value falls below $150,000, Lessor is covered for the first $50,000 of loss. The risk of loss associated with the value of the equipment falling below $100,000 is retained by Lessor Corp.

Assume Lessor Corp has already evaluated the lease classification criteria and concluded the lease is not a sales-type lease.

How should Lessor Corp classify the lease?

Analysis

Lessor Corp should classify the lease as an operating lease. When determining whether the present value of the lease payments and the residual value guarantee amount to substantially all the fair value of the underlying asset, Lessor Corp would consider the nominal amount of retained risk of $100,000, rather than the fair value of its retained risk. Assuming that the present value of the $100,000 unguaranteed residual value is great enough, the present value of the lease payments and the guaranteed residual will not amount to substantially all the fair value of the underlying asset. In that case, and considering that at lease commencement, the lease did not meet any of the criteria to be classified as a sales-type lease, the lease would not meet the criteria to be classified as a direct finance lease.

The same conclusion would be reached if the residual value guarantee was provided by Lessee Corp as opposed to a third party.

Loan guarantees and loans to the lessor

ASC 842-10-30-6 specifically excludes lessee guarantees of the lessor’s debt from the definition of lease payments and does not address loans by the lessee to the lessor. Consistent with long-standing practice, we believe that a lessee’s guarantee of the lessor’s debt or a loan to the lessor may, in some circumstances, be considered a residual value guarantee and should be treated as such in the assessment of lease classification.

For example, if the lessor’s debt is nonrecourse, or the lessor has no significant assets other than the underlying leased assets, the substance of the lessee’s remaining guarantee at the expiration of the lease term may be a guarantee of the residual value of the underlying assets. This is because there is little substantive difference between a payment by the lessee to the lessor’s nonrecourse lender pursuant to a loan guarantee and a direct payment by the lessee to the lessor under a residual value guarantee.

Portfolio level residual value guarantees

ASC 842-10-55-9 and ASC 842-10-55-10 discuss portfolio level residual value guarantees.

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.

ASC 842-10-55-10

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).

Generally, when assessing the classification criteria, a lessor should not include residual value guarantees when it applies to a portfolio of leased assets (unless they represent a single lease component) because the classification analysis is performed on an asset by asset basis and it is not possible to determine the amount of the guaranteed residual value for each individual asset.

A pooled residual value guarantee covering multiple leases can rarely be included in the assessment of the lease payments criterion when determining lease classification. The guidance in ASC 842-10-55-10 was largely carried forward from ASC 840. Under limited circumstances, however, the “portfolio effect” observed in ASC 842-10-55-9 may not exist for groups of leased assets that are similar. Consequently, and consistent with how practice evolved in this area under ASC 840, we believe it may be acceptable for a lessor to consider a pooled residual value guarantee in the assessment of the lease payments criterion if the following characteristics exist:

Each of the leases commence at the same time
The ends of the lease terms are contemporaneous
The leased assets are physically similar to one another
The variability around the expected residual values is expected to be highly correlated

The classification of a lease that includes a residual value guarantee that applies to a portfolio of leased assets by a lessee is not addressed by ASC 842. Generally, we believe a lessee should include the full amount of the potential payment payable under a residual value guarantee to each of the individual assets (unless they represent a single lease component) because the classification analysis is performed on an asset by asset basis and it is not possible to determine the amount of the guaranteed residual value for each individual asset. We believe this would apply, for example, to a single residual value guarantee in a lease of a building and the underlying land, as the building and land are always separate lease components (refer to LG 2.5 for guidance on determining lease components). However, under limited circumstances, if the four characteristics noted above are present, it may be acceptable for a lessee to include a ratable allocation of the potential payment payable under the residual value guarantee to the individual assets within the portfolio.

3.3.4.5 Fair value of the underlying asset

The lease payments criterion requires a lessee and lessor to compare the present value of lease payments and any residual value guaranteed by the lessee to the fair value of the underlying asset. The ASC 842 Glossary provides the following definition of fair value.

Definition from ASC 842 Glossary

Fair value (second definition): The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

This criterion requires the comparison of the lease payments to the fair value of the lease component (i.e., the underlying asset), not to the fair value of the right to use the asset subject to the lease arrangement. This is an important distinction because most leases are for a period shorter than the economic life of the underlying asset, therefore, the fair value of the asset and the right to use the asset will differ. Additionally, when a lease component includes multiple underlying assets, the fair value should be for the group, which may differ from the sum of the fair values of the individual assets.

Other factors, such as tax credits, may impact fair value. A lease arrangement may allow a lessor to retain certain tax credits related to the underlying asset; for example, tax credits related to the construction and ownership of the underlying asset. Tax credits are typically associated with the ownership of, not the use of, the underlying asset. Therefore, tax credits retained by the lessor should be excluded from the determination of fair value.

Fees paid to special-purpose entity owners should be excluded from the fair value of the underlying asset as discussed in ASC 842-10-30-5. However, these fees should be included as lease payments.

Excerpt from ASC 842-10-30-5(e)

Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction... shall not be included in the fair value of the underlying asset for purposes of applying paragraph 842-10-25-2(d).

ASC 842-30-55-17A includes an exception to the guidance in ASC 842-10-30-5(e) for lessors (that are not manufacturers or dealers) that allows them to use the cost of the underlying leased asset (subject to applicable volume or trade discounts) instead of fair value when assessing lease classification and measuring the lease. Thus, qualifying lessors can capitalize acquisition and delivery costs, including sales taxes, associated with the underlying asset. Because fair value, when applying the exception in ASC 842-30-55-17A, equals the qualifying lessor’s cost, no selling profit or loss is recognized at lease inception for sales-type and direct financing leases.

ASC 842-30-55-17A

Notwithstanding the definition of fair value, if a lessor is not a manufacturer or a dealer, the fair value of the underlying asset at lease commencement is its cost, reflecting any volume or trade discounts that may apply. However, if there has been a significant lapse of time between the acquisition of the underlying asset and lease commencement, the definition of fair value shall be applied.

ASC 842-10-55-3 provides guidance regarding the classification of a lease when it is not practicable for a reporting entity to determine the fair value of the underlying asset.

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).

Lessees and lessors should generally be able to estimate the fair value of an underlying asset. As suggested in ASC 842-10-55-3, any assertion that it is not practicable to arrive at such estimates would be based on facts and circumstances of the specific transaction at that point in time, and not based on a model or a policy. Given the ubiquitous use of fair value measurements throughout other accounting topics, it would be unusual for lessees or lessors to be unable to do so for purposes of classifying leases. For example, we believe entities will often be able to estimate the fair value of a portion of an asset by reference to the fair value of the entire asset, as adjusted for distinct features of the leased asset, when those significantly affect the comparison. See PwC’s Fair value measurements guide for further discussion of fair value measurements.

Question LG 3-19
Can a lessee recognize a right-of-use asset that exceeds the fair value of the underlying asset?

PwC response

ASC 842 does not specifically preclude a lessee from recording a right-of-use asset that exceeds the fair value of the underlying asset. However, it would be unusual for a lessee to knowingly pay more than fair value for an asset. Consequently, in these circumstances, a lessee should question the factors considered in the measurement of the right-of-use asset. For example, a lessee should reconsider the discount rate, the identification of lease and nonlease components, the allocation of consideration to the components, and the fair value of the underlying asset.

3.3.4.6 Discount rate

Lessees and lessors should discount lease payments at the lease commencement date using the rate implicit in the lease. If the information necessary to determine the rate implicit in the lease is not readily available, a lessee should use its incremental borrowing rate.

Rate implicit in the lease

The rate implicit in the lease is defined in the ASC 842 Glossary.

Partial definition from ASC 842 Glossary

Rate Implicit in the Lease: 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.

A lessor may be required to calculate different discount rates when classifying a lease. When evaluating the lease payments criterion to determine whether the lease is a sales-type lease, the rate implicit in the lease should include initial direct costs if, at lease commencement, the fair value of the underlying asset equals its carrying value. However, if the fair value of the underlying asset does not equal its carrying value, the rate implicit in the lease should exclude initial direct costs.

If the lease is not classified as a sales-type lease, a lessor should include initial direct costs when calculating the rate implicit in the lease to determine whether the lease is a direct finance lease or an operating lease. In this case, initial direct costs should be included regardless of whether or not the fair value of the underlying asset is equal to its carrying value.

If a lessee can ascertain the fair value of the underlying asset, the residual value estimated by the lessor, and initial direct costs incurred by the lessor, it can calculate the lessor’s implicit rate. For example, it may be possible for a lessee to calculate the rate implicit in the lease if (a) the lease includes an automatic transfer of title or a bargain purchase option because the lessor’s estimated residual value would be zero, and (b) the lessee concludes that any reasonable amount of initial direct costs would have an insignificant effect on the rate. A lessee may also be able to obtain the necessary information directly from the lessor. However, such information is rarely available to the lessee considering the sensitive nature of the information to the lessor and the potential impact it could have on existing or future lease negotiations. Accordingly, lessees and lessors will often use a different discount rate for the same lease.

Although a lessee might be able to reasonably estimate the elements required to calculate the rate implicit in the lease, it may not do so. If the rate implicit in the lease is not readily determinable, a lessee must use its incremental borrowing rate for purposes of classifying the lease and measuring the right-of-use asset and lease liability.

Question LG 3-20
When calculating the rate implicit in the lease, should the fair value of the residual asset be limited to the lease commencement date fair value of the underlying asset?

PwC response

Yes. Long standing practice has been that a lessor’s estimate of the residual value of leased property should not exceed the fair value of the leased property at lease inception. However, a literal read of the definitions of “lease receivable” and “unguaranteed residual asset” in ASC 842 may suggest it is appropriate to not limit the estimated residual value to the underlying asset’s fair value at lease commencement. This interpretation would result in a rate implicit in the lease that would consider future inflation in the asset’s fair value. This would cause most leases to be classified as operating, even those designed to be sales. It also, in the case of a sales-type lease, would result in the recognition of estimated future increases in the value of the asset at the commencement date of the lease. We do not believe these would be appropriate results. Consequently, we believe current practice should continue and the estimated residual value of a leased asset should not exceed its fair value at lease commencement.

Question LG 3-21
Would it be appropriate for a lessor to use a negative discount rate?

PwC response

No. The FASB confirmed that they did not intend for the rate implicit in the lease to be less than zero.

Incremental borrowing rate

The ASC 842 Glossary provides the following definition of incremental borrowing rate.

Definition from ASC 842 Glossary

Incremental Borrowing Rate: The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

ASC 842 requires a lessee to use a secured rate. Accordingly, the use of unsecured funding sources may not be considered, even when a lessee is not reasonably able to borrow all the funds necessary on a secured basis. The standard does not dictate the nature of the assets collateralizing the borrowing. We believe any form of collateral can be used to determine the incremental borrowing rate, as long as the borrowing is fully collateralized. Even though lessees must use a rate that is fully collateralized, a fully collateralized rate is not the same as a risk-free rate. Accordingly, lessees (other than nonpublic business entity lessees that elect to use a risk-free discount rate—see Private company considerations section below), must consider their particular credit characteristics (e.g., their credit profile) when determining their incremental borrowing rate for each lease.

The incremental borrowing rate is based on a borrowing with a term that is similar to the term of the associated lease. Therefore, when an entity is establishing the incremental borrowing rate based on a borrowing, it should ensure that the borrowing has similar payment terms as in the lease. For example, if the lease requires monthly payments, the borrowing should also have monthly payment terms. If the borrowing does not have monthly payments, then the appropriate adjustments to the rate should be made to make sure it approximates the payment terms in the lease.

When a lease includes renewal, termination, or purchase options, it is not clear whether options that are not determined to be reasonably certain of exercise (i.e., options not included in the lease term at the lease commencement date) should be considered. We believe a lessee may make an accounting policy election to either include or exclude options that are not reasonably certain of exercise when determining the term of the borrowing. While the lease term determined at lease commencement (i.e., exclusive of any options not reasonably certain of exercise) is an acceptable term to consider when determining the incremental borrowing rate, we believe the existence of options to renew or terminate a borrowing arrangement would affect the rate a lender would charge irrespective of whether or not the options are reasonably certain of exercise. Accordingly, we believe the consideration of all options in an arrangement, whether reasonably certain of exercise or not, is appropriate when determining the incremental borrowing rate and consistent with the definition and principal of the rate.

Question LG 3-22
Is a lessee limited by a loan-to-value ratio when determining the incremental borrowing rate?

PwC response

No. The loan-to-value ratio would be relevant if the collateral was limited to the right-of-use asset. However, since we believe the standard permits the use of any collateral for determining the incremental borrowing rate and the lessee must assume its borrowing is 100% collateralized, the loan-to-value ratio is irrelevant.

Question LG 3-23
Should a lessee assume the collateralized borrowing is recourse or non-recourse?

PwC response

A lessee should assume the lender has recourse to the other assets of the lessee. This assumption may result in a lower incremental borrowing rate when the lessee has sufficient other assets (e.g., a high credit quality corporation). However, if the entity has little to no other assets (e.g., a special purpose entity with no other significant assets), this assumption may have little to no impact. In either scenario, lessee specific facts and circumstances should be considered when determining the incremental borrowing rate.

Example LG 3-17 illustrates how a lessee might determine the incremental borrowing rate.

EXAMPLE LG 3-17
Incremental borrowing rate – renewal option

Lessee Corp enters into a lease of equipment with Lessor Corp. Lease payments are $100,000 per year (payable in equal monthly installments). The lease has a noncancellable term of 3 years with a 2 year renewal option. At lease commencement, Lessee Corp concludes the renewal option is not reasonably certain of exercise (i.e., the lease term is 3 years).

At lease commencement, Lessee Corp obtains the following rate quotes from its third-party lender to borrow on a fully collateralized basis:

5% interest rate to borrow $300,000 for a 3-year term (payable in equal monthly installments)
5.5% interest rate to borrow $300,000 for a 3-year term with an option to borrow an additional $200,000 at the end of 3 years for an additional 2 years (payable in equal monthly installments).

Assume Lessee Corp concludes the rates are reasonable and consistent with prevailing market rates and its historical borrowings.

Which rate should Lessee Corp conclude represents the incremental borrowing rate?

Analysis

It depends. If Lessee Corp’s accounting policy is to utilize the lease term at the lease commencement date (i.e., 3 years), the incremental borrowing rate of 5% would be appropriate.

If Lessee Corp’s accounting policy is to utilize the lease term inclusive of the renewal option, the incremental borrowing rate of 5.5% would be appropriate. This rate considers that a lender would adjust the rate to reflect the option in the arrangement to renew the borrowing for an additional 2 years even though the renewal option was not determined to be reasonably certain of exercise at the lease commencement date. Generally, the inclusion of a renewal option will increase the incremental borrowing rate, resulting in the recognition of a smaller right-of-use asset and lease liability.

Regardless of the accounting policy election made, Lessee Corp should apply the policy consistently to all leases.

Portfolio discount rate

Lessees and lessors may apply a single discount rate to a portfolio of leases if they can conclude that its application does not create a material difference when compared to individually determined discount rates applied to each of the leases in the portfolio. While a reporting entity is not required to quantitatively demonstrate immateriality, it should be able to demonstrate that the leases in the portfolio have similar characteristics, such that it is reasonable to expect that the application of the portfolio-level discount rate will not materially differ from the application of discrete discount rates at the individual lease level. When assessing materiality, reporting entities should also consider whether a small change in the discount rate could result in different lease classification, such as when the lease payments are close to substantially all of the fair value of the underlying assets. Example LG 3-18 demonstrates this concept.

EXAMPLE LG 3-18
Discount rate – portfolio discount rate

Lessee Corp enters into 20 separate leases with Lessor Corp for a fleet of similar vehicles; each vehicle is of similar make and model, although certain features may vary (e.g., interior, radio, electronics). Each lease has a term of three years. Depending on the vehicle’s particular features, annual fixed lease payments range from $3,750 to $4,000. There are no purchase options or renewal options.

Can Lessee Corp and Lessor Corp apply a single discount rate to the portfolio of leases?

Analysis

Assuming the underlying assets are similar, have similar lease terms, the value and range of lease payments do not vary greatly, interest rates have remained stable throughout the evaluation period, and that the lease payments do not approach substantially all of the fair value of the underlying assets, it is reasonable to conclude that the application of a single portfolio-level discount rate would not create a material difference in classification when compared to applying individually determined discount rates to each of the leases in the portfolio.

Question LG 3-24
Would it be appropriate for a subsidiary to use the incremental borrowing rate of its parent?

PwC response

It depends. We believe it may be acceptable for a subsidiary to use its parent’s incremental borrowing rate if the subsidiary can demonstrate that the lessor looked to the parent’s credit standing when negotiating lease terms. This would be evident if the parent guarantees the subsidiary’s lease. Using a reasonable lender standard (i.e., what knowledge would a reasonable lender have when pricing debt), we believe this assertion can also be substantiated when one of the following factors are present:

The parent has a central treasury function with cash pooling arrangements between the parent and all subsidiary lessees; the parent regularly “sweeps” cash in and out to centrally manage liquidity
The lease is contractually linked to other general parent obligations
The lease includes covenants that are tied to the creditworthiness of the parent
The parent’s internal funding arrangements provide a full backstop for the lease obligation of the subsidiary lessee

Private company considerations

ASC 842-20-30-3 provides a practical expedient for entities that are not public business entities, which allows a lessee to use a risk-free rate for a period comparable to the lease term. Since a risk-free rate is lower than an incremental borrowing rate for a specific entity, it will result in a higher lease liability and right-of-use asset. Use of a risk-free rate is an accounting policy election and was originally required to be applied consistently for all leases upon election. However, in response to concerns raised in the post implementation review, to provide more flexibility and reduce implementation costs, in November 2021, the FASB issued ASU 2021-09, Discount Rate for Lessees That Are Not Public Business Entities. Upon adoption, ASU 2021-09 permits entities other than public business entity lessees to apply this election to leases by class of underlying asset, rather than to all leases. Lessees choosing this election should, nevertheless, use the rate implicit in the lease when it is readily determinable. See LG 9.2.4 and LG 9.7.2 for disclosure requirements, and LG 10.11 for the effective date and transition requirements, of ASU 2021-09.

The expedient to use a risk-free rate may only be elected by lessees that are not public business entities. Other lessees may not use a risk-free rate in lease classification or measurement.

3.3.4.7 Collectibility (lessors)

Lessors are required to evaluate whether lease payments, and any amount necessary to satisfy a residual value guarantee, are probable of collection, as discussed in ASC 842-30-25-3 for sales-type leases. A sales-type lease is similar to a sale of the underlying asset. As such, when there is significant concern regarding the collectibility of payments due under the terms of the contract, sale treatment may be delayed.

ASC 842-30-25-3

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

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

The term “probable” is defined in US GAAP as “likely to occur,” and is generally interpreted as at least a 75% likelihood. A lessor’s assessment of probability of collection should be performed at lease commencement and reflect both the lessee’s ability and intent to pay as amounts become due considering all relevant facts and circumstances. See RR 2.6.1.5 for additional information on assessing the probability of collection.

If a lessor concludes at lease commencement that the lease meets the criteria to be classified as a sales-type lease, but collection of lease payments or any amount due to satisfy a residual value guarantee is not probable, the lessor should not derecognize the asset or recognize any selling profit. Any lease payments received should be recorded as a deposit liability until either of the criteria outlined in ASC 842-30-25-3 occurs. See LG 4.3.1 for guidance addressing how to account for a lease once the collectibility criteria are met.

Direct financing leases should be classified as an operating lease if lease payments, plus any amount necessary to satisfy a residual value guarantee, including third party guarantees, are not probable of collection at lease commencement. The lessor cannot classify the lease as a direct financing lease because the conversion of the lessor’s asset risk to credit risk (which occurs when a lessor effectively transfers the risks and rewards of ownership of the underlying asset to the lessee) is nonsubstantive.

Even when a lease is classified as an operating lease, the lessor should still assess the collectibility of payments. At lease commencement, if a lessor determines that operating lease payments are not probable of collection, the recognition of lease income is limited to the lesser of the following:

Lease income that would have been recorded to date (i.e., straight-line rental income), plus variable lease payments
Lease payments, including variable lease payments, received to date

3.3.5 Underlying asset is of a specialized nature

A lease of an underlying asset that 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 should be classified as a sales-type or direct financing lease by the lessor. This is because a lessor would be expected to price the lease to ensure it receives a return of its initial investment plus interest from the lessee. For example, if a lessor invests in the construction of a gas pipeline that will connect land owned by the lessee to a main pipeline and the pipeline has no alternative use beyond the lessee’s need to transport gas, the lessor would be expected to price the lease to ensure a return during the noncancellable term of the lease.

The evaluation of whether an underlying asset is expected to have an alternative use to the lessor at the end of the lease term should consider any contractual restrictions and practical limitations on the lessor’s ability to change or redirect the use of the underlying asset, as discussed in ASC 842-10-55-7.

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 a 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.

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

Table of contents
3.3 Lease classification criteria

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3.3 Lease classification criteria

3.3.1 Transfer of ownership

3.3.2 Purchase options

3.3.2.1 Purchase option prices

3.3.3 Lease term test

3.3.3.1 Determining the term of the lease

3.3.3.2 Determining the estimated economic life

3.3.3.3 Economic life involving multiple assets

3.3.4 Lease payment tests

3.3.4.1 Fixed lease payments

3.3.4.2 Lease incentives

3.3.4.3 Variable lease payments

3.3.4.4 Residual value guarantees

3.3.4.5 Fair value of the underlying asset

3.3.4.6 Discount rate

3.3.4.7 Collectibility (lessors)

3.3.5 Underlying asset is of a specialized nature

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3.3 Lease classification criteria

3.3.1 Transfer of ownership

3.3.2 Purchase options

3.3.2.1 Purchase option prices

3.3.3 Lease term test

3.3.3.1 Determining the term of the lease

3.3.3.2 Determining the estimated economic life

3.3.3.3 Economic life involving multiple assets

3.3.4 Lease payment tests

3.3.4.1 Fixed lease payments

3.3.4.2 Lease incentives

3.3.4.3 Variable lease payments

3.3.4.4 Residual value guarantees

3.3.4.5 Fair value of the underlying asset

3.3.4.6 Discount rate

3.3.4.7 Collectibility (lessors)

3.3.5 Underlying asset is of a specialized nature

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