Substantial changes are underway for lessee accounting under Topic 842, Leases. However, lessor accounting remains relatively unchanged under the new lease standard. Changes under the new standard are intended to align lessor accounting with lessee accounting guidance, as well as parts of Topic 606, Revenue from Contracts with Customers (Topic 606). For most lessors, the main impact of Topic 842 implementation on their financial statements is additional disclosures.
Lessor Lease Classification
There are three types of lease classifications under Topic 842 lessor accounting:
- sales-type leases,
- direct financing leases, and
- operating leases.
The types of leases are the same as under legacy GAAP for lease accounting, Topic 840, but there are some changes in the classification criteria.
The lessor classifies the lease as a sales-type lease if any of the following criteria are met (per ASC 842-10-25-2):
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
- 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.
Direct Financing Lease
If none of the sales-type criteria are met and both of the following criteria are met, the lessor would classify the lease as a direct financing lease (per ASC 842-10-25-3):
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f), and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.
- It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.
If the lease does not meet either of the classification criteria discussed above, then it is classified as an operating lease by the lessor.
Changes to Lessor Accounting Under Topic 842
The main changes under Topic 842 relate to lease classification, treatment of lessor costs, and recognition of lease income.
Sales-Type Leases and Direct Financing Leases
The updated lease classifications for sales-type leases and direct financing leases are based on whether the lessor transfers control of the leased asset to the lessee. Previously, under Topic 840, classification for such leases was based on whether there was a manufacturer/dealer profit or loss. This change was made to align lessor accounting with lessee accounting guidance under Topic 842.
Under Topic 842, lease classification is not reassessed unless the underlying lease is modified. A lease modification is a change to the terms and conditions of a contract that results in a change in the scope of, or the consideration for, a lease. For example, a lease modification may take place at the time an option to extend a lease term or purchase the underlying asset is exercised. This change was made to align lessor accounting with contract modification accounting to sellers of goods and services under Topic 606.
When determining lease classification, lessees with collectability uncertainties are no longer prevented from being classified as a sales-type lease, unlike under Topic 840. Additionally, Topic 842 includes specific guidance for lease income recognition when collectability of lease payments is not probable.
Significant Variable Payments
Prior to the adoption of Accounting Standards Update No. 2021-05 (ASU 2021-05), leases with significant variable payments could be classified as sales-type leases or direct financing leases, even if the classification resulted in a selling loss. This was not allowed under Topic 840.
Further, the classification as a leveraged lease is eliminated under Topic 842. Under previous accounting guidance, a leveraged lease occurred when there was a long-term creditor providing non-recourse financing. As a practical expedient, Topic 842 allows for leveraged leases with a lease commencement date prior to the effective date of Topic 842 to continue to be accounted for as a leveraged lease under Topic 840. Modifications to leveraged leases after the effective date of Topic 842 are subject to Topic 842 at the modification date.
Initial Direct Costs
Initial direct costs are defined in Topic 842 as incremental costs of a lease that would not have been incurred if the lease was not executed. This narrowed definition will result in certain costs, such as legal fees, to be expensed as incurred under Topic 842. These costs were previously capitalized under Topic 840.
Lessee payments of lessor executory costs, such as lessor insurance costs, are allocated to the lease and non-lease components under Topic 842. Under Topic 840, these costs were excluded from lease accounting.
Lease Income Recognition
Allocation of Consideration
In allocating consideration in the contract to the lease and non-lease components, lessors apply transaction price allocation guidance in Topic 606 under the new lease standard. Previously, under Topic 840, lessors applied the relative stand-alone selling price approach under Topic 605, Multiple Element Arrangements (Topic 605). This will primarily effect contracts that were subject to bundled discounts and variable consideration.
Recognition of Selling Profit
Under Topic 842, selling profit for direct-financing leases will be deferred and recognized over the lease term. Direct financing lease are rarely expected to have a selling profit.
Disclosures Under Topic 842
The new lease standard requires both quantitative and qualitative disclosures to be included in lessor financial statements. Under Topic 840, the lessor was only required to disclose the total income from lease payments. The following quantitative disclosures should be presented in tabular format under Topic 842:
- Profit or loss recognized at lease commencement date
- Interest income from the net investment in the lease
- Income from operating lease payments
- Income from variable lease payments not included in the lease receivable
The following qualitative disclosures are required for lessors under Topic 842:
- A general description of leases
- The basis, terms, and conditions for variable lease payments
- The existence, terms, and conditions for options to extend or terminate the lease
- The existence, terms, and conditions for purchase options of the leased asset
- Information of significant assumptions and judgements made, including determining if a contract is a lease, allocation of consideration between lease and non-lease components, and determination of an unguaranteed residual asset
- Information on how the lessor manages residual risk association with leases, including lessor’s risk management strategy for residual assets, carrying amount of residual assets covered by guarantees, and others means the lessors utilizes to mitigate residual risk
Under Topic 840, the qualitative disclosure requirements for lessors involved a general description of leases along with information on contingent lease payments. All other qualitative disclosures are newly required under Topic 842.
The following disclosures for lessors remain substantially the same under Topic 842 as compared to legacy GAAP:
- A lessor must disclose the components of the net investment in its sales-type leases and direct financing leases. However, under Topic 842, any significant changes in the components of the net investment should be explained, which is a new requirement.
- A maturity analysis of lease receivables (sales-type leases and direct financing leases) or future lease payments (operating leases), breaking out the next five years of cash flows and the total thereafter to be collected
- Disclosure of related party leases
Overall, updates under Leases (Topic 842) have been made to better align lessor and lessee accounting standards. It is important for you and your client to be aware of these guidance changes so that all parties accurately disclosing their financial statements. If you have questions regarding the Topic 842 updates, please contact us, and we’ll be happy to help.
Kate is a manager in Clark Nuber’s Audit and Assurance Services Group.
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