FASB Accounting Standards Codification Topic 842 (“ASC 842”) is possibly the most impactful accounting standards change for many organizations in recent memory. With all the focus on lessee entities, some lessors are feeling overlooked. But we want to fix that. After all, there wouldn’t be lessees without lessors!
The good news is that lessors are significantly less impacted since lessor accounting was substantially unchanged. However, key aspects of lessor accounting have been aligned with the new lessee guidance in ASC 842 and the revenue recognition guidance in ASC 606. So, what do you need to know?
- Lessors will continue to classify leases as operating, sales-type or direct financing.
- The purchase option criterion no longer requires a “bargain purchase option,” only that the purchase option is reasonably certain to be exercised by the lessee.
- The bright-line tests of 75% of the remaining economic life and 90% of the fair value have been replaced by principles-based tests of a major part of the economic life and substantially all of the fair value. However, the 75% and 90% thresholds still remain reasonable approaches to applying these classification criteria.
- A new criterion was added. If the underlying asset 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, the lease should be classified as a sales-type lease.
- The differentiation between sales-type and direct-financing leases is no longer based on whether there is manufacturer or dealer profit (or loss). Rather, the difference is whether the lessor effectively transfers control of the underlying asset to the lessee (sales-type), or the lessor transfers substantially all the risks and benefits of ownership of the underlying asset to the lessee and/or an unrelated third-party (direct-financing).
- Leases under which collectability of lease payments is not probable at commencement are no longer precluded from sales-type lease classification. ASC 842 provides specific guidance for accounting when collectability is uncertain, which involves recognizing payments received as a deposit liability.
- Leases under which contract consideration is primarily variable could be classified as any of the three types. When a lease meets any of the criteria to be classified as either sales-type or direct-financing, but the significance of variable consideration would result in recognition of selling loss at commencement, the lessor must classify the lease as an operating lease.
- For real estate leases, there is no longer a requirement for automatic transfer of title at the end of the lease term to be classified as a sales-type lease.
- The leveraged lease classification no longer exists for new leases under ASC 842. Existing leases accounted for as leveraged leases under ASC 840 will continue to be accounted for as such until the lease contract is either modified or terminated.
When selling profit is realized from a direct-financing lease, it is deferred and recognized over the lease term. Because such leases would have been classified as sales-type leases under ASC 840, this will result in delayed profit recognition compared to the prior guidance.
ASC 842 narrows the definition of initial direct costs to include only costs that would not have been incurred if the lease had not been executed. Therefore, certain costs that were capitalized under ASC 840 (such as certain legal fees and internal payroll) will be expensed as incurred under ASC 842. This will result in accelerated expense recognition.
Lessee payments of lessor executory costs (lessor property tax, insurance, etc.) are not a “component” of the contract and rather are allocated to lease and nonlease components in the same manner as all other lease payments. They are not excluded from lease classification and measurement as they were under ASC 840.
- If a lessee makes payments for these “non-components” directly to the lessor, the lessor will include these amounts in its gross revenues and expenses. However, if the lessee makes the payments directly to a third-party, the lessor will exclude them.
- Note that maintenance is a nonlease component under ASC 842, not an executory cost as it was under ASC 840.
As an accounting policy election by class of underlying asset, lessors may elect not to separate lease and nonlease components, and instead account for each lease component and its related nonlease component(s) as a single component, as long as:
- The nonlease component would otherwise be accounted for in accordance with ASC 606,
- The timing and pattern of transfer for the lease component and nonlease component(s) associated with that lease component are the same, and
- The lease component, if accounted for separately, would be classified as an operating lease.
If a lessor elects to not separate lease and nonlease components, the lessor should account for the combined component in accordance with ASC 606 if the nonlease component(s) is (are) the predominant component(s). Otherwise, the lessor would account for the lease in accordance with ASC 842.
Lessors are required to present lease assets (i.e., net investment in sales-type and direct-financing leases) separately from all other assets in the statement of financial position.
ASC 842 expands disclosure requirements for lessors to include additional information regarding variable lease payments; contract options related to extension, termination or purchase; and other significant assumptions, judgments and policy elections used in applying the requirements of ASC 842.
The adoption of ASC 842 is not expected to have a significant impact on amounts previously reported under ASC 840, assuming the available transition practical expedients are used. Lessors will have the choice to apply the guidance either as of the beginning of the earliest period presented (comparative reporting) or as of the beginning of the period of adoption (results in non-comparative reporting).
As you can see, the impacts for lessors are primarily related to classification, timing and presentation. Overall, lessor financial statements will not change significantly as a result of adoption of ASC 842. However, there are a few decisions to be made (transition method, use of transition practical expedients and treatment of nonlease components). Our accounting professionals are available to answer questions you have about these changes or other aspects of ASC 842.