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As discussed in LG 3, leases are classified by a lessor as either a sales-type, direct financing, or operating lease. While lessees are required to record a lease liability and right-of-use asset for all leases, the model applied by lessors depends on the type of the lease. The following sections discuss initial recognition for the lessor.

4.3.1 Sales-type lease

A lessor should classify a lease that meets any of the criteria in ASC 842-10-25-2 as a sales-type lease (see LG 3.3 for lease classification criteria). In a sales-type lease, the lessor transfers control of the underlying asset to the lessee. Accordingly, the lessor should derecognize the leased asset and record its net investment in the lease at lease commencement (consistent with the principle of a sale in ASC 606). As discussed in ASC 842-30-30-1, the net investment in the lease consists of the lease receivable and the unguaranteed residual asset.
The unguaranteed residual asset is the present value of the lessor’s estimated value of the leased asset returned to it at the end of the lease term, less a residual value guarantee, if any. There is no unguaranteed residual asset for the lessor when the lessee retains the underlying asset at the end of the lease term, as would be the case when a lease either transfers ownership to the lessee or a purchase option is reasonably assured of exercise.
ASC 842-30-30-1 describes the measurement of a lessor’s net investment in a sales-type lease.

ASC 842-30-30-1

At the commencement date, for a sales-type lease, a lessor shall measure the net investment in the lease to include both of the following:
a. The lease receivable, which is measured at the present value, discounted using the rate implicit in the lease, of:
1. The lease payments (as described in paragraph 842-10-30-5) not yet received by the lessor
2. The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor. The unguaranteed residual asset at the present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease.

The lessor should recognize any profit or loss arising from the sale of the underlying asset (through the lease).
Initial direct costs should be recognized as an expense unless the fair value of the underlying asset equals its carrying amount (i.e., there is no selling profit or loss). When there is no selling profit or loss, the initial direct costs should be deferred and recognized over the lease.

4.3.1.1 Sales type lease — Selling profit/loss

At the lease commencement date, the lessor is required to calculate the selling profit or loss as (1) the fair value of the underlying asset (or the sum of lease receivable and any prepaid lease payments by lessee, if lower); minus (2) the carrying amount of the underlying asset net of any unguaranteed residual asset; minus (3) any deferred initial direct costs of the lessor. The sales price in a sales-type lease is assumed to be the fair value of the underlying asset unless the present value of the lease payments is lower than the fair value of the asset. This could be the case when the lease has an unguaranteed residual asset that reduces the receivable recognized at lease commencement. This should not have a significant impact on the selling profit or loss, however, because the present value of the unguaranteed residual asset is also subtracted from the carrying amount of the underlying asset (i.e., a cost of sales). See Example LG 4-7 for an illustration of how to calculate selling profit when a lease contains an unguaranteed residual value.
Substantial variable payments
It is common for suppliers in certain industries to structure transactions with significant variable payments. Suppliers in these industries are willing to accept variability in payments because they believe such arrangements would be profitable overall and lower fixed payments can make an arrangement attractive to the customer.
There are instances when transactions with significant variable payments may qualify as a transfer of control to the customer under the new revenue recognition standard (ASC 606). Such transactions may also qualify as a sales-type lease under the new leases guidance. This is because the revenue standard states that the transfer of title is only one of the indicators for control being transferred to a customer.
Whether a transaction with variable payments is subject to the revenue guidance or the leases guidance may impact when revenue is recognized by a supplier. Under the leases standard, variable payments that do not depend on an index or rate are not recognized until the contingency is resolved. Under the new revenue recognition standard, variable payments may be recognized as revenue upfront (when earned) provided certain conditions are met.
When a transaction with significant variable payments qualifies as both a sale under the new revenue recognition standard and a lease under the new leases standard, the leases standard should be applied, unless the practical expedient discussed in LG 2.4.4.1 is elected and the entire transaction is accounted for under the ASC 606 revenue standard. Under the lease classification criteria, it is possible for lease arrangements with significant variable lease payments to be classified by lessors as a sales-type lease. This may lead to the recognition of an initial loss ( i.e., a “Day 1” loss) by the lessor even if the overall arrangement is expected to be profitable. See Example LG 4-9 for an illustration of a lease with significant variable payments.
Note about ongoing standard setting
In October 2020, the FASB issued an exposure draft for targeted improvements and amendments to the leases standard. Under the proposed guidance, lessors would be required to classify the lease as operating if the variable lease payments that do not depend on an index or rate are predominant and recognize income for the variable lease payments in the period earned. As of the cut-off date of this guide, the proposed amendments have not yet been issued. Reporting entities should continue to monitor the status of these proposed amendments and any additional updates to the leases standard.
Presentation
Lease classification does not determine how selling profit or loss should be presented in a lessor's income statement. Presentation should be determined by the lessor's business model; when leases are used as an alternative means of realizing value from the goods that it would otherwise sell, a sales-type lease should be recorded as revenue and cost of goods sold. See LG 9.3.2.1 for information on the presentation of selling profit or loss in the statement of comprehensive income.

4.3.1.2 Initial direct costs in a sales-type lease

The guidance for identifying initial direct costs is the same for a lessor as it is for a lessee. Additionally, the term "initial direct costs" under the new leases guidance is the same as incremental costs of obtaining a contract under the new revenue guidance. The two terms are intended to be applied in the same manner in terms of which costs get capitalized.
Initial direct costs may be more significant for a lessor because they are usually the party that solicits lessees as part of their sales activities, are often the party to engage attorneys to prepare the legal documents, and often pay commissions incurred in connection with execution of a lease. See LG 4.2.2.2 for information on initial direct costs and Figure LG 4-1 for the examples of costs included and excluded from initial direct costs.
A lessor should expense the initial direct costs associated with a sales-type lease unless the fair value of the underlying asset equals its carrying amount (i.e., there is no selling profit or loss). This accounting is similar to the accounting for a seller's costs in a contract for similar goods. See RR 11.2 for information on a seller's accounting for contract costs.
Initial direct costs incurred in connection with a sales-type lease with no selling profit or loss should be deferred and recognized over the lease term using a method that produces a constant periodic rate of return on the lease when combined with the interest income on the lease receivable and the residual asset (i.e., in the same manner as for a direct financing lease).
In arrangements that include both lease and nonlease components, the initial direct costs should be allocated to the various components and accounted for in accordance with the guidance applicable to each component. Initial direct costs may be treated differently depending upon the nature of the nonlease components.

4.3.1.3 Sales-type lease — Collectibility not probable

ASC 842-30-25-3 to ASC 842-30-25-6 describes how a lessor should recognize and measure a sales-type lease when collectibility of the lease receivable is not probable at the commencement date.

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:
a. 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.
b. 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.

ASC 842-30-25-4

When collectibility is not probable at the commencement date, at the date the criterion in paragraph 842-30-25-3(a) is met (that is, the date at which collectibility of the lease payments plus any amount necessary to satisfy a residual value guarantee provided by the lessee is assessed as probable), the lessor shall do all of the following:
a. Derecognize the carrying amount of the underlying asset
b. Derecognize the carrying amount of any deposit liability recognized in accordance with paragraph 842-30-25-3
c. Recognize a net investment in the lease on the basis of the remaining lease payments and remaining lease term, using the rate implicit in the lease determined at the commencement date
d. Recognize selling profit or selling loss calculated as:
1. The lease receivable; plus
2. The carrying amount of the deposit liability; minus
3. The carrying amount of the underlying asset, net of the unguaranteed residual asset.

ASC 842-30-25-5

When collectibility is not probable at the commencement date, at the date the criterion in paragraph 842-30-25-3(b) is met, the lessor shall derecognize the carrying amount of any deposit liability recognized in accordance with paragraph 842-30-25-3, with the corresponding amount recognized as lease income.

When collectibility of the lease receivable from a sales-type lease is not probable at the original commencement date, the lessor should defer the recognition of the sale until collectibility becomes probable. This is consistent with the collectibility guidance in ASC 606, which similarly states that a supplier should defer recognition of a sale to a customer if collectibility of the consideration is not probable.
In such circumstances, a lessor should not derecognize the underlying assets at the lease commencement date, and should not recognize a net investment in the lease and selling profit or loss (other than initial direct costs). Instead, it should recognize all lease payments received as a deposit liability until the earlier of when collectibility becomes probable or the contract is terminated or completed and the lease payments it received are nonrefundable. Initial direct costs associated with the lease should be expensed at the original lease commencement date. During this period, the lessor should not recognize interest expense on the deposit liability, and it should continue to depreciate the underlying asset.
When collectibility subsequently becomes probable, a lessor should derecognize the carrying amount of the underlying asset and deposit liability from its balance sheet and recognize the net investment in the lease as well as any selling profit or loss. After making these adjustments, a lessor should follow the subsequent measurement guidance for a sales-type lease (see LG 4.5.1).
If the collectibility of lease payments or guaranteed residual value do not become probable before the contract is terminated, or it repossesses the underlying asset and the lease payments are nonrefundable, a lessor should derecognize the carrying amount of any deposit liability recognized with the corresponding amount recognized as lease income. The lessor should continue to apply the impairment guidance in ASC 360 to the underlying asset.

ASC 842-30-25-6

If collectibility is probable at the commencement date for a sales-type lease or for a direct financing lease, a lessor shall not reassess whether collectibility is probable. Subsequent changes in the credit risk of the lessee shall be accounted for in accordance with the impairment guidance applicable to the net investment in the lease in paragraph 842-30-35-3.

If the collectibility of lease payments and any residual value guarantee is deemed to be probable at the commencement date, any subsequent deterioration in the lessee's credit quality will not require a lessor to change its accounting or classification of a lease. However, the lessor's net investment in the lease would be subject to the financial instruments impairment guidance in ASC 310 and any deterioration in the credit quality of the lessee should be captured through an impairment charge. However, a lessor should consider the guidance for credit losses in ASC 326, Financial Instruments - Credit Losses, once that guidance is adopted. See LG 4.7 for further discussion on impairment.

4.3.1.4 Examples – lessor accounting for sales-type leases

Example LG 4-7, Example LG 4-8 and Example LG 4-9 illustrate a lessor's accounting for a sales-type lease.
EXAMPLE LG 4-7
Sales-type lease recognition – non-specialized digital imaging equipment lease (lessor)
Lessor Corp enters into a lease of non-specialized digital imaging equipment with Lessee Corp on 1/1/X9. Lessor Corp is a manufacturer of digital imaging equipment that uses both direct sales and leases as a means of selling its products. The following table summarizes information about the lease and the leased assets.
Lease term
5 years, no renewal option
Remaining economic life of the leased equipment
6 years
Purchase option
None
Annual lease payments
$1,100
Payment date
Annually on January 1 (first payment is made at lease commencement)
Fair value of the leased equipment at commencement
$5,000
Lessor Corp’s carrying value of the leased equipment
$4,500
Rate implicit in the lease
7.04%
Other
  • Title to the asset remains with Lessor Corp upon lease expiration
  • Lessee Corp does not guarantee the residual value of the equipment at the end of the lease term and Lessor Corp does not obtain any third-party residual value insurance
  • Estimated fair value of the equipment at the end of the lease term is $250
  • Lessee Corp pays for all maintenance of the equipment separate from the lease
  • There are no initial direct costs incurred by Lessor Corp
  • Lessor Corp does not provide any incentives
How would Lessor Corp measure and record this lease at commencement?
Analysis
Based on the facts Lessor Corp could reasonably conclude that the lease is a sales-type lease as the lease term is a major part of the remaining economic life of the equipment (see LG 3 for lease classification criteria).
Lessor Corp would first determine the total net investment in the lease as the present value of the lease receivable and the unguaranteed residual asset.
  • The present value of the lease receivable is equal to the present value of the remaining lease payments discounted at 7.04%; this amount is $3,722.
  • The present value of the unguaranteed residual asset discounted at 7.04% is $178.
  • Lessor Corp’s net investment in the lease is $3,900 (the sum of the lease receivable ($3,722) and the unguaranteed residual asset ($178)).
To determine the selling profit or loss arising from the lease, Lessor Corp would calculate the difference between the fair value of the underlying asset (or the lease receivable plus any proceeds received at or before lease commencement, if lower) and the carrying amount of the underlying asset net of any unguaranteed residual asset. Since the present value of the lease receivable plus the upfront proceeds ($4,822) is lower than the fair value of the underlying asset ($5,000), the selling profit is calculated as follows:
Present value of the lease receivable
$3,722
Plus, the lease payment received at lease commencement
1,100
Less, the carrying value of leased asset ($4,500) net of unguaranteed residual asset ($178)
(4,322)
Selling profit
$500
Lessor Corp would record revenue at lease commencement equal to the lease receivable amount plus the lease payment received at lease commencement ($4,822). Cost of goods sold would be recorded as the difference between the carrying value of the leased asset ($4,500) and the discounted value of the unguaranteed residual asset ($178).
Lessor Corp would record the following journal entry on the lease commencement date.
Dr. Lease receivable
$3,722
Dr. Cash
$1,100
Dr. Unguaranteed residual asset
$178
Dr. Cost of goods sold
$4,322
Cr. Property, plant and equipment (leased asset)
$4,500
Cr. Revenue
$4,822
View table
See Example LG 4-15 for an illustration of the subsequent measurement and recognition for this fact pattern.
EXAMPLE LG 4-8
Sales-type lease recognition – real estate with a purchase option (lessor)
Lessor Corp enters into a property (land and building) lease with Lessee Corp on January 1, 20X9. 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.
Remaining economic life
40 years
Fair value of the leased property at commencement
$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. Lessee Corp is reasonably certain to exercise this option.
Annual lease payments
The first annual payment is $500,000, with increases of 3% per year thereafter (see schedule below).
Payment date
Annually on January 1 (first payment is made at lease commencement)
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
  • Title to the property does not automatically transfer to Lessee Corp upon lease expiration
  • Lessee Corp does not guarantee the residual value of the real estate asset
  • Lessee Corp pays for all maintenance, taxes, and insurance on the property separate from the lease
  • There are no initial direct costs incurred by Lessor Corp
The schedule of lease payments (excluding the purchase option exercise price) is shown below.
Date
Amount
Lease commencement
$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
*See LG 9 for presentation considerations for the lease incentive receivable.
Lessor Corp uses leases for the purposes of providing financing, therefore it presents any selling profit or loss in a single line item in the income statement. See LG 9.3.2.1 for information on the presentation of selling profit or loss in the statement of comprehensive income.
How would Lessor Corp measure and record this lease at commencement?
Analysis
Based on the facts Lessor Corp could reasonably conclude that the lease is a sales-type lease because it grants Lessee Corp a fixed price purchase option to purchase the asset underlying the lease and Lessee Corp is reasonably certain to exercise that purchase option (see LG 3.3 for classification criteria).
Lessor Corp would first determine the total net investment in the lease by calculating the present value of the lease receivable and the unguaranteed residual asset.
  • The present value of the lease receivable is $4,500,000. This is the present value of the remaining fixed lease payments, less the lease incentives payable to Lessee Corp, plus the exercise price of the purchase option discounted at approximately 9.04%, the rate implicit in the lease. The exercise price of the purchase option is included in the lease receivable because it is reasonably certain that Lessee Corp will exercise the option.
  • Since it is reasonably certain that Lessee Corp will exercise its purchase option, Lessor Corp does not expect to derive any additional value from the underlying asset; therefore, the unguaranteed residual asset value is zero.
  • Lessor Corp’s net investment in the lease is $4,500,000 (the sum of the lease receivable ($4,500,000) and the unguaranteed residual asset ($0)).
Lessor Corp would record the following journal entry on the lease commencement date.
Dr. Lease receivable
$4,500,000
Dr. Cash
$500,000
Cr. Property, plant and equipment (leased asset)
$5,000,000
View table
EXAMPLE LG 4-9
Sales-type lease recognition – lease with significant variable payments
Lessor Corp will install an x-ray machine in a hospital (customer/lessee) and maintain it for a period of five years. Lessor Corp can substitute the x-ray machine only in the event of malfunction, which is expected to be infrequent. The customer will make all operational decisions (e.g., decide in which department the x-ray machine will be used, hours of its operation) and its employees will operate the machine. The customer will be responsible for providing all of the consumables needed (e.g., x-ray films, chemicals). The customer will bear the risk of loss in the event of damage or theft and will be responsible for purchasing insurance to protect against physical loss of the machine.
As is customary in this industry, Lessor Corp does not intend to repossess the machine at the end of the term. Consequently, the customer may decide to continue to use the machine or scrap it after the five-year period.
The supply of x-ray machines is part of Lessor Corp's ongoing major or central operations. Other facts of the arrangement are:
Lease term
5 years (noncancellable)
Remaining economic life
5 years
Payments from the customer
$5/click of the x-ray machine to take an x-ray Fixed maintenance fee of $2,000/year for 5 years (payable at the end of each month)
Variable payments estimate during the term of the arrangement
$125,000
Fair value of the leased asset at commencement
$100,000
Lessor Corp's carrying value of the leased asset
$80,000
Estimated fair value of the leased asset at the end of 5 years
$0
Standalone price for leasing a similar asset for 5 years
$100,000
Standalone price for maintenance for 5 years
$10,000
Inception date and commencement date
January 1
Other
Collectibility of payments from the customer is probable
Lessor Corp has not made an accounting policy election to not separate the lease and nonlease components for this class of asset.
How should Lessor Corp account for the lease component at commencement date?
Analysis
The arrangement contains two components - a lease component (the lease of the x-ray machine) and a nonlease component (the maintenance services).
The lease component qualifies as a sales-type lease because the lease term is for the major part of the remaining economic life of the X-ray machine (see LG 3.3 for lease classification criteria).
Contract consideration is $10,000 ($2,000 × 5), which is the fixed amount for maintenance over the five years. Contract consideration excludes the $5/click because it relates to the lease component and is a variable payment that does not depend on an index or a rate. Therefore, Lessor Corp would allocate the contract consideration between the components under the new leases guidance as follows:
Component
Standalone price
(A)
Allocation % (A/$110,000)
(B)
Allocation of contract consideration
(B*$10,000)
Lease
$100,000
90.91%
$9,091
Maintenance
10,000
9.09%
909
Total
$110,000
100%
$10,000
View table
At lease commencement, Lessor Corp would record the following journal entries.
Dr. Lease receivable
$9,091
Dr. Cost of goods sold
$80,000
Cr. Inventory
$80,000
Cr. Revenue
$9,091
View table
The $70,909 loss at the commencement of the lease ($80,000 - $9,091) occurs due to the exclusion of variable payments from contract consideration. The rate implicit in the lease is negative because the sum of (1) the lease payments ($9,091) and (2) the estimated residual value of the machine at the end of the lease term ($0) is less than the machine's fair value at the lease commencement date ($100,000). However, it would not be appropriate for a lessor to use a negative discount rate as the rate implicit in the lease. Therefore, the lessor must use a rate of 0% and not discount the receivable.

4.3.2 Direct financing lease

When a lease is not a sales-type lease but meets the criteria to be classified as a direct financing lease (see LG 3.3 for lease classification criteria), the lease transaction effectively converts the lessor’s risk arising from the underlying asset (that is, asset risk) into credit risk. Consequently, the most faithful representation of a lessor’s involvement in a lease that transfers substantially all of the risks and rewards incidental to ownership of the underlying asset to a lessee is to recognize the lessor’s financial net investment in the lease and recognize financial (interest) income on that net investment over the lease term.
As described in ASC 842-30-25-7, a lessor should derecognize the leased asset underlying a direct financing lease and record a net investment in the lease at lease commencement. The net investment in the lease should be measured in the same manner as a sales-type lease adjusted for selling profit and initial direct costs. See LG 4.3.1 for information on measuring the net investment in a sales-type lease. Any selling profit and initial direct costs should be deferred and included in the net investment in the lease. These amounts should be recognized over the lease term in a manner that will produce, when combined with the interest income on the lease receivable and the residual asset, a constant periodic rate of return on the lease (see ASC 842-30-55-31 through ASC 842-30-55-39 for an illustrative example). Selling losses should not be deferred.

4.3.2.1 Direct financing lease — Initial measurement

ASC 842-30-30-2 provides guidance of the measurement of the net investment in a direct financing lease. (Note that ASC 842-30-30-1(a) and ASC 842-30-30-1(b) are reproduced in LG 4.3.1.)

ASC 842-30-30-2

At the commencement date, for a direct financing lease, a lessor shall measure the net investment in the lease to include the items in paragraph 842-30-30-1(a) through (b), reduced by the amount of any selling profit.

Selling profit is not recognized at the commencement of a direct financing lease because it does not transfer control of the underlying asset to the lessee. This treatment is consistent with the principle of a sale in ASC 606. However, when a lease meets the criteria to be classified as a direct financing lease, it transfers substantially all the risks and rewards of ownership of the underlying asset to one or more third parties and effectively converts the lessor’s risk arising from the underlying asset into credit risk. Therefore, the most faithful representation of a lessor’s involvement in such a lease is to recognize the lessor’s financial net investment in the lease (excluding selling profit) and recognize selling profit as interest income on that net investment.
The different ways of measuring the net investment in a lease for a sales-type lease and a direct financing lease (i.e., a sales-type lease includes the selling profit recognized at commencement) results in the same total income but differences in the timing of income recognition. Another difference in the initial measurement of a net investment in a sales-type lease versus that recorded for a direct financing lease is the accounting for initial direct costs. In a sales-type lease, initial direct costs ordinarily are expensed as incurred and are excluded in the computation of the rate implicit in the lease. In a direct financing lease (and in a sales-type lease when the fair value of the underlying asset equals its carrying amount), the initial direct costs are deferred and included in the net investment in the lease and thus are included in the calculation of the rate implicit in the lease.
As discussed in LG 4.3.1.3, in a sales-type lease, collectibility only impacts sale recognition. In a direct financing lease, however, collectibility impacts lease classification. As described in LG 3.3.4.7, when collectibility of lease payments or the residual value guarantee is not probable at lease commencement, a lessor should classify the lease as an operating lease, even though it would otherwise have met the criteria for classification as a direct financing lease. The classification of such leases are not reassessed when there is a subsequent improvement in the lessee’s credit quality (i.e., these operating leases remain classified as operating leases even when the collectibility subsequently become probable). See LG 4.3.3.1 for the recognition and measurement of an operating lease when collectibility is not probable.

4.3.3 Operating lease — lessor

An operating lease is neither a sale nor financing of an asset. The lessor should keep the asset underlying the lease on its balance sheet and continue to depreciate the asset based on its estimated useful life. Rental revenue should be recognized on a straight-line basis (or another systematic basis if that basis is more representative of the pattern in which income is earned from the underlying asset over the term of the respective lease). A lessor should record an unbilled rent receivable, which is the amount by which straight-line rental revenue exceeds rents currently billed in accordance with the lease.
Questions often arise as to whether a lessor should recognize uneven rent payments on some basis other than straight-line if the rent increases are designed to reflect estimated future market rents. Although these type of rent increases are common in real estate leases, we believe that the income should be recorded on a straight-line basis even in these situations.

4.3.3.1 Operating lease — Collectibility is not probable

ASC 842-30-25-12 describes the recognition and measurement for a lessor in an operating lease when collectibility of the lease payments plus any amount necessary to satisfy the residual value guarantee is not probable at the commencement date.

ASC 842-30-25-12

If collectibility of the lease payments plus any amount necessary to satisfy a residual value guarantee (provided by the lessee or any other unrelated third party) is not probable at the commencement date, lease income shall be limited to the lesser of the income that would be recognized in accordance with paragraph 842-30-25-11(a) through (b) or the lease payments, including variable lease payments, that have been collected from the lessee.

ASC 842-30-25-13

If the assessment of collectibility changes after the commencement date, any difference between the lease income that would have been recognized in accordance with paragraph 842-30-25-11(a) through (b) and the lease payments, including variable lease payments, that have been collected from the lessee shall be recognized as a current-period adjustment to lease income.

The initial recognition and measurement for an operating lease is not impacted by the collectibility of the payments from the lessee. The lessor continues to recognize the underlying asset on its balance sheet and continues to depreciate the asset based on its estimated useful life. However, subsequent to initial recognition, a lessor's lease income is limited to the lesser of the straight-line rental income (or another systematic basis if that basis is more representative of the pattern in which income is earned from the underlying asset over the term of the respective lease) or the lease payments that have been collected from the lessee.
When the collectibility of the lease payments subsequently becomes probable, the lessor should recognize the difference between the cumulative lease income recognized to date and the amount that would have been recognized had the lessor followed the measurement guidance for an operating lease without the limitation described in ASC 842-30-25-12. The amount is recorded as an adjustment to lease income in the period in which collectibility is first deemed probable. After such adjustment, the lessor should follow the general guidance for subsequent measurement of an operating lease (see LG 4.5.2). Lessors are required to continually assess collectibility over the lease term (see LG 8.9 for subsequent accounting considerations).

4.3.3.2 Examples – lessor accounting for operating leases

Example LG 4-10 illustrates a lessor’s accounting for an operating lease.
EXAMPLE LG 4-10
Lessor operating lease recognition – automobile lease
Lessor Corp leases an automobile to Lessee Corp on January 1, 20X9. The following table summarizes information about the lease and the leased asset.
Lease term
3 years, no renewal option
Remaining economic life of the automobile
6 years
Fair value of the automobile at commencement
$30,000
Lessor Corp’s carrying value of the automobile at commencement
$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 for the first year
$550 for the second year
$600 for the third year
Payment date
Beginning of the month (first payment is made at lease commencement)
Rate implicit in the lease
8%
Other
  • Title to the automobile remains with Lessor Corp upon lease expiration
  • The expected residual value of the automobile at the end of the lease term is $19,000; Lessee Corp does not guarantee the residual value of the automobile at the end of the lease term
  • Lessee Corp pays for all maintenance of the automobile separate from the lease
  • There are no initial direct costs incurred by Lessor Corp
  • Lessor Corp does not provide any incentives
How would Lessor Corp measure and record this lease at commencement?
Analysis
Based on the facts Lessor Corp could reasonably conclude that the lease is an operating lease as none of the criteria for sales-type or direct financing lease treatment have been met (see LG 3.3 for classification criteria). Since the lease is classified as an operating lease, no asset or liability would be recorded at lease commencement. Lessor Corp would keep the automobile on its books as an asset and depreciate it in accordance with its normal depreciation policy.
See Example LG 4-16 for an illustration of the subsequent measurement and recognition for this fact pattern.

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