Under ASC 842
, a lessor’s pattern of revenue recognition for an operating lease is impacted by its assessment of the collectibility of lease payments. If collectibility is probable at commencement, lease income is generally recognized on an accrual basis (generally on a straight-line basis) over the term of the lease. Otherwise, lease income is limited to the lesser of (1) income that would have been recognized if collectibility was probable, or (2) lease payments collected (i.e., a cash basis).
Collectibility should be reassessed during the lease term. If collectibility is no longer probable (i.e., the lease subsequently becomes “troubled”), and cumulative cash receipts are less than lease income recognized to date, the excess lease income would be reversed. If collectibility changes back to probable, any difference between the lease income that would have been recognized if collectibility was always probable and the income actually recognized to date is recognized as current period lease income, assuming the original agreement has not been modified or replaced. Probability in this context is assessed based on the credit standing of the lessee, and as such, collection issues arising from disputes over the calculation of variable rents should not be considered in a lessor’s evaluation of collectibility.
The new leases standard does not address whether, after performing a probability assessment under ASC 842
, lessors can continue to record a general reserve under ASC 450
, for operating lease receivables that are probable of collection. At its July 17, 2019 Board meeting, the FASB clarified that lessors can elect an accounting policy to record a general reserve under ASC 450
for a portfolio of operating lease receivables that are probable of collection. This election does not need to be consistent with the accounting policy applied under the prior leases guidance, ASC 840
If a lessor elects to record a general reserve, it may either be recorded as a reduction in revenue or as bad debt expense. A lease that subsequently becomes troubled would need to be removed from the general reserve pool and the associated lease receivable written-off. We believe the following methods can be used to write off the lease receivable.
- If a lessor elects to apply the general reserve model and elects to record the reserve as a reduction in revenue, the lessor should remove a troubled lease from the general pool by writing it off through lease income.
- If a lessor elects to apply a general reserve model and elects to record the reserve as bad debt expense, the lessor can elect one of two acceptable policies to remove a troubled lease from the general reserve pool:
- Discrete calculation: Write off the gross receivable from the troubled lease through lease income. Separately recalculate the general reserve exclusive of the troubled lease, recognizing the change in bad debt expense.
- Net presentation: Write off the existing lease receivables balance net of the general allowance attributable to that lease through lease income.
Example LG 8-2 illustrates the application of the gross and net presentation alternatives.
EXAMPLE LG 8-2
Application of the gross and net presentation alternatives
A lessor has several operating leases (after the adoption of ASC 842
). The lessor believes collection of lease receivables is probable and applies a general reserve for the aggregate receivables that was recorded to bad debt expense. As of December 31, 20X1, the lessor had a $1,000 deferred operating lease receivables balance (due to straight-lining of lease income) and a $50 general allowance against the entire portfolio of the outstanding receivables balance. On June 30, 20X3, the lessor determined that one of the leases in the portfolio, Lease X, was no longer probable of collection. At that time, the allowance for doubtful accounts attributable to Lease X was $6 and the outstanding gross lease receivable balance for Lease X was $100. As substantially all of the lease payments are not deemed collectible for Lease X, ASC 842
requires the lessor to recognize revenue only as cash is received.
How would the lessor write off the lease receivable?
The lessor would write off the gross receivable for Lease X through lease income and reverse the previously-recorded general allowance attributable to Lease X with a contra expense. The journal entries would be as follows:
Dr. Allowance for doubtful accounts
The lessor would write-off the lease receivable balance for Lease X, net of the allowance, through lease income. The journal entry would be as follows:
Dr. Allowance for doubtful accounts
If the assessment of collectibility subsequently changes from not probable to probable (without a lease modification), the lessor would book a cumulative adjustment to lease income to re-establish the accrued deferred operating lease receivable as though the cash basis of accounting had never been applied.