Lessor issues: implementing the new leases accounting standard

Lessors’ accounting for leases is substantially unchanged by the new leases Accounting Standard Update No. 2016-02 (ASC 842). However, there are some relevant changes lessors should take note of.

Definitions

• Lessor: An entity that enters into a contract to provide the right to use an underlying asset for a period of time in exchange for consideration.
• Underlying asset: An asset that is subject to the lease for which a right to use has been conveyed to the lessee. The underlying asset could be a physically distinct portion of a single asset.

Lease classification

There are no substantive changes for lessors with respect to lease classification. Lessors will still classify leases as operating, sales-type or finance type leases. The classification criteria is the same as for lessees, as follows:

A lessor shall classify a lease as a sales-type lease if any of the following criteria is met:

• 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.1

If none of these criteria are met, the lessor will classify the lease as an operating lease unless both of the following criteria are met and then the lessor will classify the lease as a direct financing lease:

1. 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.
2. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.2

Lease modifications

If an operating lease is modified in a way that does not terminate the initial lease but creates a new lease, the lessor needs to evaluate the terms of the modified lease to determine classification following this guidance:

• If the modified lease is classified as an operating lease, the lessor shall consider any prepaid or accrued lease rentals relating to the original lease as a part of the lease payments for the modified lease.
• If the modified lease is classified as a direct financing lease or a sales-type lease, the lessor shall derecognize any deferred rent liability or accrued rent asset and adjust the selling profit or selling loss accordingly.3

If a direct financing lease is modified and not considered a new lease, the lessor should apply the following guidance:

• If the modified lease is classified as a direct financing lease, the lessor shall adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease immediately before the effective date of the modification.
• If the modified lease is classified as a sales-type lease, the lessor shall account for the modified lease in accordance with the guidance applicable to sales-type leases in Subtopic 842-30, with the commencement date of the modified lease being the effective date of the modification. In calculating the selling profit or selling loss on the lease, the fair value of the underlying asset is its fair value at the effective date of the modification and its carrying amount is the carrying amount of the net investment in the original lease immediately before the effective date of the modification.
• If the modified lease is classified as an operating lease, the carrying amount of the underlying asset equals the net investment in the original lease immediately before the effective date of the modification.4

Leveraged leases

For leveraged leases in effect at the effective date of ASC 842, the extant accounting model continues until the end of the lease term. The new standard does not recognize the concept of leveraged leases for any leases entered into after the effective date.

Sale leaseback transactions

ASC 842 articulates the guidance for sale leaseback with ASC 606, Revenue from Contracts with Customers. Therefore, if the sale meets the criteria in ASC 606 to be recognized as revenue to the seller, the buyer lessor will account for the lease in accordance with ASC 842.

If the sale does not qualify for recognition in accordance with ASC 606, then the buyer lessor will not recognize the transferred asset and will record any amounts paid on the lease as a receivable in accordance with other topics.

Under ASC 842, there is no longer a distinction between real estate leases and non-real estate leases; therefore, all of the specialized guidance with respect to real estate sale leasebacks is not carried over into ASC 842.

Transition requirements for lessors

As noted above, the objective within ASC 842, with respect to lessors, was basically to not have any significant changes in measurement and accounting models. As such, for:

Operating leases:

1. Continue to recognize the carrying amount of the underlying asset and any lease assets or liabilities at the later of the date of initial application and the commencement date as the same amounts recognized by the lessor immediately before that date in accordance with Topic 840.
2. Account for previously recognized securitized receivables as secured borrowings in accordance with other Topics.
3. Write off, as an adjustment to equity, any unamortized initial direct costs at the later of the beginning of the earliest period presented in the financial statements or the commencement date of the lease that do not meet the definition of initial direct costs in this Topic (unless the lessor elects the practical expedients described in (f)).5

Sales-type and direct financing leases:

1. Continue to recognize a net investment in the lease at the later of the beginning of the earliest comparative period presented in the financial statements and the commencement date of the lease, at the carrying amount of the net investment at that date. This would include any unamortized initial direct costs capitalized as part of the lessor’s net investment in the lease in accordance with Topic 840.
2. Before the effective date, a lessor shall account for the lease in accordance with Topic 840.
3. Beginning on the effective date, a lessor shall account for the lease in accordance with the recognition, subsequent measurement, presentation and disclosure guidance in Subtopic 842-30.
4. Beginning on the effective date, if a lessor modifies the lease (and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8), it shall account for the modified lease in accordance with paragraph 842-10-25-16 if the modified lease is classified as a direct financing lease after the modification or paragraph 842-10-25-17 if the modified lease is classified as a sales-type lease after the modification. A lessor shall not re-measure the net investment in the lease on or after the effective date unless the lease is modified (and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8). 

ASC 842 also provides guidance on accounting for leveraged leases or sales leasebacks that exist at the transition date. Here again, the goal is for the lessor entity not to encounter any significant change from current accounting.

Disclosure requirements

Disclosure requirements are extensive and include qualitative, as well as the expected quantitative, information required historically. Some of the qualitative disclosures are:

• Significant assumptions and judgments made in applying the standard, including whether a contract contains a lease, allocations between lease and non-lease components and the amount lessor expects to earn from the underlying asset at the end of the lease term
• Basis for determining variable lease payments

Conclusion

While the transition for lessors will not be as onerous as for lessees, there are considerations that lessor entities should make and these entities should evaluate their processes and controls if they have historically been active in sale leaseback or leveraged leases.

For more information on this topic, or to learn how Baker Tilly can help with the transition to the new leasing standard, please contact our team.

1 ASC 842-10-25-2

2 ASC 842-10-25-3

3 ASC 842-10-25-15

4 ASC 842-10-25-16

5 ASC 842-10-65-1

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