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Understanding the Leasing Standard: Part 3 - Lessor Accounting

Aug. 23, 2016

The discussion about the new lease accounting standard largely centers on the changes made to lessee accounting. Although the Financial Accounting Standards Board (FASB) determined that lessor accounting did not need the same comprehensive improvements, Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) still makes significant changes to the guidance for lessors.

In Part 3 of our Understanding the Leasing Standard serial, lessor accounting changes will be explored in more detail.

Overview

Among the largest changes to lessors will be the lease classification test, which modifies the accounting for sales-type and direct financing leases. The special accounting treatment for leveraged leases is eliminated for new leases on the effective date of the new lease accounting standard, although leveraged leases that exist at the transition date will be grandfathered.

The new guidance is effective for public business entities for annual periods beginning after December 15, 2018 and interim periods within those years. For all other entities, the new guidance is effective for annual periods beginning after December 15, 2019 and interim periods beginning after December 15, 2020. Early adoption is permitted for all entities.

Criteria for Lease Classification by Lessors

Lessors will run through the following five lease classification criteria to determine whether they have sales-type, direct financing or operating leases:

  • 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, unless the commencement date falls at or near the end of the economic life of the asset;
  • 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 equals or exceeds “substantially all” of the fair value of the underlying asset; or
  • 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.

If at least one of the criteria is met, the lessor has a sales-type lease. If none of the criteria is met, a lessor classifies a lease as a direct financing lease when the present value of the sum of the lease payments and any residual guarantees equals or exceeds "substantially all" of the fair value of the underlying assets and collection of the lease payments and residual value guarantees is probable. All leases not classified as sales-type or direct financing leases are classified as operating leases.

It is important to note that a key difference between the sales-type and direct financing lease classification tests is the treatment of residual value guarantees provided by unrelated third parties. A lessor is required to include the full amount of a residual value guarantee provided by a lessee in its evaluation of whether a lease is a sales-type lease. However, if a lease does not qualify as a sales-type lease, a lessor includes the full amounts of residual value guarantees provided by both lessees and any other third party unrelated to the lessor in its evaluation of the “substantially all” criterion of the lease classification test to determine whether a lease is a direct financing lease.

Accounting for Sales-Type Leases

Lessors will account for sales-type leases using an approach that is similar to current sales-type lease accounting. Lessors will derecognize the carrying amount of the underlying asset, recognize the net investment in the lease and recognize, in net income, any selling profit or selling loss. However, if collection of lease payments and any residual value guarantee provided by the lessee is not probable at lease commencement, a lessor does not derecognize the underlying asset and does not recognize its net investment in the lease. Instead, a lessor continues to account for the underlying asset using other U.S. generally accepted accounting principles (GAAP) and recognizes lease payments received, including variable lease payments that do not depend on an index or rate, as a deposit liability until the earlier of the following:

  • Collectibility of lease payments plus amounts necessary to satisfy a residual value guarantee provided by the lessee becomes probable, or
  • The lease is terminated or the underlying leased asset is repossessed.

Accounting for Direct Financing Leases

Lessors will account for direct financing leases using an approach that is similar to the accounting for sales-type leases for which collectibility is probable. However, for a direct financing lease, any selling profit is deferred at lease commencement and included in the initial measurement of the net investment in the lease. The lessor recognizes interest income over the lease term in an amount that produces a constant periodic discount on the remaining balance of the net investment in the lease. Any selling loss on a direct financing lease is recognized immediately at lease commencement.

Accounting for Operating Leases

The accounting for operating leases under the new standard is largely unchanged from the current GAAP.

At the commencement of an operating lease, the lessor will continue to recognize the underlying asset and defer initial direct costs and amortize them over the lease term. After commencement of the lease, the lessor will recognize lease payments as income, generally on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which the benefit is expected to be derived from the underlying asset. Lessors will recognize variable lease payments as income when they occur and test for impairment of the underlying asset.

Presentation of Leases

Lessors with sales-type and direct financing leases will present their lease assets (net investments in the leases) separately from other assets. Those with operating leases will present their underlying assets in accordance with ASC 360, Property, Plant, and Equipment.

In the statement of comprehensive income, a lessor should present lease income either as separate line items or as disclosures in the notes that include the line items that contain the lease income.

When a company uses leasing as an alternative means of realizing value from the goods that it would otherwise sell, it should present revenue and cost of goods sold relating to its leasing activities in separate line items so that the presentation of income and expenses from sold and leased items is consistent. When a company uses leasing for the purposes of providing financing, the lessor should present the profit or loss in a single line item.

Lessors should classify lease cash receipts within operating activities in their statement of cash flows.

Disclosures

As with lessee accounting, the disclosure requirements for lessors have been expanded. In general, lessors will be required to provide more information about the nature of their leases and subleases. This includes a general description and the existence and terms and conditions related to variable lease payments, options to extend or terminate the lease and options for the lessee to purchase the underlying asset. Related party transactions will have to be disclosed.

Lessors will also have to provide information about significant assumptions and judgments used in their determination of whether a contract contains a lease, allocation of contract consideration and determination of the amount the lessor expects to derive from the underlying asset following the end of the lease term.

Another required disclosure is how lessors manage the risk associated with the residual value of the leased assets, including the risk management strategy used, the carrying amount of residual assets covered by residual value guarantees not considered lease payments for the lessor and any other means the lessor uses to reduce its residual value asset risk.

When evaluating their enhanced disclosure requirements, lessors should consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the various requirements. Disclosures should be combined or separated so that useful information is not lost in insignificant details or buried in items that have different characteristics.

For their quantitative disclosures, lessors should place those related to lease income in tabular format. Sales-type and direct financing leases will require disclosures of the profit or loss recognized at the commencement date and interest income in aggregate or separated by components of the net investments in the leases. Operating leases will be required to disclose lease income related to lease payments. All types of leases will separately disclose lease income relating to variable lease payments not included in the measurement of the lease receivable.

Sales-type and direct financing leases will also have to disclose the components of the net investments in leases, which is the lease receivable, unguaranteed residual assets and any deferred selling profit. Lessors with these types of leases will also be required to explain significant changes in the balance of unguaranteed residual assets and any deferred selling profit. They will provide a maturity analysis of undiscounted lease receivables reconciled to the statement of financial position. The maturity analysis should cover a minimum of five years and include a total for the remaining years.

Operating leases require a maturity analysis of undiscounted lease payments to be received. These disclosures should be separated from the analysis of any sales-type or direct financing leases. Lessors with operating leases will also follow the guidance required by ASC 360, Property, Plant and Equipment for underlying assets of operating leases separately from owned assets.

Examine All Leases Carefully

Lessor accounting for leases received several updates, so lessors should carefully consider how existing leases or leases that are up for renewal will be affected by the new leasing standard. In addition to the general guidance, the new leasing standard will also affect specific types of arrangements. 

Up Next

In our next edition of our Understanding the Leasing serial, we will explore the changes to subleases, sale and leaseback transactions and lessee involvement in construction.

Previous Editions

For More Information

If you have any specific comments, questions or concerns about the changes to lessor accounting, please contact Heather Winiarski or Hal Hunt of MHM's Professional Standards Group. Heather can be reached at hwiniarski@cbiz.com or 816.945.5168. Hal can be reached at hhunt@cbiz.com or 816.945.5610.

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