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3.6 Lessor classification examples
Publication date: 31 May 2023
us Leases guide
A lessor should determine lease classification based on whether the lease effectively represents a financing or a sale, as opposed to simply conveying usage rights, by determining whether the lease transfers substantially all of the risks and rewards of ownership of the underlying asset. Generally, this approach yields a conclusion that is consistent with existing US GAAP for direct financing leases, sales-type leases, and operating leases.
At lease commencement, a lessor should not recognize selling profit and revenue if the lease does not also transfer control of the underlying asset to the lessee. While this represents a change from existing US GAAP, it aligns with the concept of what constitutes a sale in the new revenue recognition standard.
The following examples illustrate some of the items that lessors will need to consider when classifying leases:
- Sales type lease: Example LG 3-24 and Example LG 3-25
- Operating lease: Example LG 3-26
EXAMPLE LG 3-24
Lease classification – non-specialized digital imaging equipment lease (lessor)
Lease classification – non-specialized digital imaging equipment lease (lessor)
Lessor Corp enters into a lease of non-specialized digital imaging equipment with Lessee Corp. The following table summarizes information about the lease and the leased assets.
Lease term
| 5 years, no renewal option
|
Economic life of the equipment
| 6 years
|
Purchase option
| None
|
Annual lease payments
| $1,100
|
Payment date
| Annually on January 1
|
Fair value of the leased equipment
| $5,000
|
Lessor Corp’s carrying value of the leased equipment
| $4,500
|
Rate implicit in the lease
| 7.04%
|
Other
|
|
How should Lessor Corp classify the lease?
Analysis
Lessor Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and ASC 842-10-25-3.
Criteria | Analysis |
Transfer of ownership
| Ownership of the asset does not transfer to Lessee Corp by the end of the lease term.
|
Purchase option which the lessee is reasonably certain to exercise
| The lease does not contain a purchase option.
|
Lease term is for the major part of the remaining economic life of the asset
| Lessee Corp is utilizing the asset for approximately 83% of the economic life of the asset (5-year lease/6-year economic life), which is deemed to be a major part.
|
Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset
| The present value of the lease payments (discounted at the rate Lessor Corp charges in the lease of 7.04%) is $4,822.
Therefore, the present value of the lease payments amounts to approximately 96% of the fair value of the leased asset ($4,822/$5,000), which is deemed to be substantially all of the fair value of the leased asset.
|
Specialized nature
| The digital imaging equipment is non-specialized and could be used by another party without major modifications.
|
Lessor Corp should classify the lease as a sales-type lease because the lease term is for a major part of the economic life of the equipment and the present value of the lease payments amounts to substantially all of the fair value of the underlying asset. Accordingly, Lessee Corp has obtained control of the underlying asset, which is economically similar to Lessor Corp selling the asset to Lessee Corp.
See Example LG 4-7 for an illustration of the initial recognition and measurement of this type of lease.
EXAMPLE LG 3-25
Lease classification – real estate lease with a purchase option (lessor)
Lease classification – real estate lease with a purchase option (lessor)
Lessor Corp enters into a property (land and building) lease with Lessee Corp. The following table summarizes information about the lease and the leased asset.
Lease term
| 10 years
|
Renewal option
| Five 5-year renewal options
If exercised, the annual lease payments are reset to then current market rents.
|
Economic life
| 40 years
|
Fair value of the property
| $5,000,000
|
Lessor Corp’s carrying value of the leased property
| $5,000,000
|
Purchase option
| Lessee Corp has an option to purchase the property at the end of the lease term for $3,000,000.
|
Annual lease payments
| The first annual payment is $500,000, with increases of 3% per year thereafter.
|
Payment date
| Annually on January 1
|
Incentive
| Lessor Corp gives Lessee Corp a $200,000 incentive for entering into the lease (payable at the beginning of year 2), which is to be used for normal tenant improvements.
|
Rate implicit in the lease
| Approximately 9.04%
|
Other
|
|
How should Lessor Corp classify the lease?
Analysis
Lessor Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and ASC 842-10-25-3.
Criteria | Analysis |
Transfer of ownership
| Ownership of the asset does not transfer to Lessee Corp by the end of the lease term.
|
Purchase option which the lessee is reasonably certain to exercise
| The lease contains an option to purchase the property for $3,000,000, which is below the fair value of the real estate asset at lease commencement and its expected value at the date of exercise. Options to purchase real estate at a price below commencement date fair value are generally considered to be reasonably certain of exercise since real estate generally appreciates in value. Thus, a significant economic incentive to exercise the purchase option exists.
|
Lease term is for the major part of the remaining economic life of the asset
| The lease term is 10 years; the five 5-year renewal options available to Lessee Corp are not reasonably certain of exercise (determined at lease commencement) because they require rent to be reset to market rates at the time of exercise.
Therefore, Lessee Corp is utilizing the asset for 25% of the economic life of the asset (10-year lease/40-year economic life), which is not deemed to be a major part.
|
Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset
| The lease payments net of the incentive Lessor Corp pays Lessee Corp are $5,531,940 (see below for a schedule of payments). The present value of the lease payments (discounted at the rate Lessor Corp charges in the lease of approximately 9.04%) is $3,737,510.
Because the purchase option is reasonably certain of being exercised, it should be included as a lease payment at the end of the lease term. Using the rate Lessor Corp charges Lessee Corp (approximately 9.04%), the present value of the purchase option is $1,262,490.
Therefore, the present value of the lease payments equals 100% of the fair value of the leased asset (($3,737,510 + $1,262,490)/$5,000,000).
|
Specialized nature
| Although the property is in a specific location, it could be used by another party without major modifications.
|
The following table shows the schedule of lease payments.
Date | Amount |
Year 1 | 500,000 |
Year 2 (515,000 – 200,000 lease incentive) | 315,000 |
Year 3 | 530,450 |
Year 4 | 546,364 |
Year 5 | 562,754 |
Year 6 | 579,637 |
Year 7 | 597,026 |
Year 8 | 614,937 |
Year 9 | 633,385 |
Year 10 | 652,387 |
Total | $5,531,940 |
Lessor Corp should classify the lease as a sales-type lease because at lease commencement, Lessee Corp is reasonably certain to exercise its fixed-price purchase option at the end of the initial lease term (i.e., after 10 years). As a result, Lessee Corp has effectively obtained control of the underlying asset, which is economically similar to Lessor Corp selling the underlying asset to Lessee Corp. Due to the exercise price of the option, the lease would also result in payments equal to substantially all of the fair value of the underlying asset.
See Example LG 4-8 for an illustration of the initial recognition and measurement of this type of lease.
EXAMPLE LG 3-26
Lease classification – automobile lease (lessor)
Lease classification – automobile lease (lessor)
Lessor Corp leases an automobile to Lessee Corp. The following table summarizes information about the lease and the leased asset.
Lease term
| 3 years, no renewal option
|
Economic life of the automobile
| 6 years
|
Fair value of the automobile
| $30,000
|
Lessor Corp’s carrying value of the automobile
| $30,000
|
Purchase option
| Lessee Corp has the option to purchase the automobile at fair market value upon expiration of the lease.
|
Monthly lease payments
| $500
|
Payment date
| Beginning of the month
|
Rate implicit in the lease
| 9.56%
|
Other
|
|
How should Lessor Corp classify the lease?
Analysis
Lessor Corp should assess the lease classification using the criteria outlined in ASC 842-10-25-2 and ASC 842-10-25-3.
Criteria | Analysis |
Transfer of ownership
| Ownership of the asset does not transfer to Lessee Corp by the end of the lease term.
|
Purchase option which the lessee is reasonably certain to exercise
| At lease commencement, Lessee Corp is not reasonably certain to exercise the purchase option because it is at fair market value, which does not provide a significant economic incentive.
|
Lease term is for the major part of the remaining economic life of the asset
| Lessee Corp is utilizing the asset for 50% of the economic life of the asset (3-year lease/6-year economic life), which is not deemed to be a major part.
|
Sum of present value of lease payments and any residual value guarantee by the lessee amounts to substantially all of the fair value of the underlying asset
| The present value of the lease payments (discounted at the rate Lessor Corp charges in the lease of 9.56%) is $15,720.
Therefore, the present value of the lease payments amounts to approximately 52% of the fair value of the leased asset ($15,720/$30,000), which is not deemed to be substantially all of the fair value of the leased asset.
|
Specialized nature
| The automobile is non-specialized and could be used by another party without major modifications.
|
Lessor Corp should classify the lease as an operating lease because none of the criteria in ASC 842-10-25-2 or ASC 842-10-25-3 have been met.
See Example LG 4-10 for an illustration of the initial recognition and measurement of this type of lease.
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.
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