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4.3 Initial recognition and measurement – lessor
Publication date: 30 Sep 2021
us Leases guide
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.
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). See LG 4.3.1.1 for more details.
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.
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 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 variable payments qualifies as both a sale under the new revenue recognition standard and a sales-type lease under the new leases standard, the leases standard should be applied. This may lead to the recognition of a selling loss (i.e., a day-one loss) by the lessor even if the overall arrangement is expected to be profitable. In response to concerns raised in the post implementation review, the FASB published ASU 2021-05, which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on a rate or index) 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 selling loss. Operating lease lessors can elect an optional practical expedient to aggregate nonlease components that otherwise would have been accounted for under the new revenue standard with the associated lease component and account for the combined component under the revenue standard if certain conditions are met. See LG 9.11 for the effective date and transition requirements of ASU 2021-05. See Example LG 4-9 for an illustration of a lease with variable payments. See LG 2.4.4.1 for the component practical expedient available to lessors.
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 FSP 14.3.2.1 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.
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.
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.
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.
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 and Example LG 4-8 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)
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
|
|
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 |
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)
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
|
|
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 FSP 14 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 FSP 14.3.2.1 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 |
Example LG 4-9 illustrates a lessor’s accounting for a lease with variable lease payments that result in a day-one loss under a sales-type lease classification (assuming the lessor has adopted ASU 2021-05).
EXAMPLE LG 4-9
Lessor’s accounting for a lease with variable lease payments that result in a day-one loss under a sales-type lease classification (assuming the lessor has adopted ASU 2021-05)
Lessor’s accounting for a lease with variable lease payments that result in a day-one loss under a sales-type lease classification (assuming the lessor has adopted ASU 2021-05)
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.
Lessor Corp has adopted ASU 2021-05, Lessors – Certain Leases with Variable Lease Payments.
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 |
The lease would be classified as a sales-type lease since the lease term equals the remaining economic life of the asset. However, in this example, the application of sales-type lease accounting would result in a day-one loss of $70,909 at commencement ($9,091 consideration allocated to the lease minus $80,000 carrying value of the leased asset) since the only fixed payments required under the contract total $10,000. As such, the lease must be classified as operating under ASU 2021-05, which this example assumes has been adopted by Lessor Corp.
As the lease is classified as an operating lease, Lessor Corp will continue to reflect the x-ray machine on its balance sheet at its carrying value and depreciate it in accordance with Lessor Corp’s normal depreciation policy. See LG 4.5.2 for the subsequent accounting for an operating lease.
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. See LG 4.3.2.1 for the accounting for selling losses due to variable lease payments.
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.)
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.
An arrangement with variable lease payments that is classified as a direct financing lease may lead to a selling loss or a day-one loss even if the overall arrangement is expected to be profitable. In response to concerns raised in the post implementation review, the FASB published ASU 2021-05, which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on a rate or index) as an operating lease at the lease commencement date if classifying the lease as a direct financing lease (or sales-type lease) would result in recognition of a selling loss. See LG 9.11 for the effective date and transition requirements of ASU 2021-05.
4.3.3 Operating lease — lessor
An operating lease is neither a sale nor financing of an asset. In addition, upon adoption of ASU 2021-05, ASC 842 also requires a lessor to classify a lease with variable lease payments (that do not depend on a rate or index) as an operating lease at the lease commencement date if classifying the lease as a sales-type or a direct financing lease would result in recognition of a selling loss. If a lease is classified as operating, 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 from lease payments 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). See LG 9.11 for the effective date and transition requirements of ASU 2021-05. Based on the definition of lease payments in ASC 842-10-30-5(f), a lessor should not include any residual value guarantee from a lessee as a lease payment. 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.
Excerpt from 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:
...
f. 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).
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.
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.
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 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
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3 years, no renewal option
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Remaining economic life of the automobile
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6 years
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Fair value of the automobile at commencement
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$30,000
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Lessor Corp’s carrying value of the automobile at commencement
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$30,000
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Purchase option
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Lessee Corp has the option to purchase the automobile at fair market value upon expiration of the lease.
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Monthly lease payments
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$500 for the first year
$550 for the second year $
600 for the third year
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Payment date
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Beginning of the month (first payment is made at lease commencement)
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Rate implicit in the lease
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8%
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Other
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|
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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