The Financial Accounting Standards Board (FASB) issued an amendment to Topic 842 Leases that improves lessor accounting for leases classified as sales-type or direct financing with variable lease payments not dependent on an index or rate and that result in a commencement date selling loss. Under Topic 842, variable lease payments that do not depend on a reference rate or index are excluded from a lessor’s measurement of its net investment in the lease for both sales-type and direct financing leases. An example of variable lease payments that are not dependent on an index or reference rate is a lease with variable payments based on the usage of the underlying asset.
These amendments, which were codified in Accounting Standard Update 2021-05, Leases (Topic 842): Lessors — Certain Leases with Variable Lease Payments (the “ASU”), were issued in response to feedback received from practitioners as part of the FASB’s post-implementation review process. Lessors that have not yet adopted Topic 842 will apply the amendments in the ASU when Topic 842 is initially adopted using the same transition method for both. Lessors that are public business entities will apply the amendments in the ASU in fiscal years, including interim periods within those fiscal years, beginning after Dec. 15, 2021. All other lessors that have adopted Topic 842 as of Jul. 19, 2021 (the date the ASU was issued), will apply the amendments in this ASU for fiscal years beginning after Dec. 15, 2021, and in interim periods within fiscal years beginning after Dec. 15, 2022. Early adoption is permitted, but not before the adoption of Topic 842. Reporting entities that have adopted Topic 842 before the issuance of the ASU may apply the amendments either (1) retrospectively to leases that commenced or that were modified on or after the reporting entity’s initial adoption of Topic 842; or (2) prospectively to leases that commence on or that are modified on or after the date the reporting entity initially applies the amendments in the ASU.
Topic 842 Prior to Accounting Standard Update 2021-05
A lessor classifies a lease as sales-type if it meets any of the five classification criteria (see ASC 842-10-25-2 for the general lease classification criteria applied by lessees and lessors) and, if none of those five classification criteria are met, as a direct financing lease if it meets both of the additional classification criteria for lessors (see ASC 842-10-25-3(b) for the additional lease classification criteria applied by lessors to determine whether a lease that does not meet the criteria for classification as sales-type should be classified as direct financing). A lessor classifies leases that do not meet any lease classification criteria as operating. Under Topic 842, a lessor excludes variable lease payments that do not depend on a reference rate or index when measuring lease payments, thus, they are also excluded from the measurement of a lessor’s net investment in the lease. Lessors recognize variable lease payments that do not depend on a reference rate or index when the contingencies around their variability are resolved.
As a result of them being excluded when measuring lease payments, variable lease payments not based on an index or rate could result in a lessor’s net investment in the lease having a lower carrying value than that of the underlying asset, which would result in the lessor incurring a commencement date selling loss on a sales-type or direct financing lease. Accordingly, prior to adopting the ASU, there is an increased likelihood of accounting outcomes that do not reflect the economics underlying sales-type and direct financing leases with variable lease payments not based on an index or rate, including situations in which the lessor anticipates a lease to be profitable over its term through, for example, the expected collection of lease payments dependent on the lessee’s usage of the underlying asset.
Provisions of Accounting Standard Update 2021-05
The FASB has received feedback including concerns that the accounting outcome described above (i.e., commencement date selling loss) does not faithfully represent the underlying economics of certain leases at both commencement and over the lease term. In response, the FASB issued the ASU to allow leases that would otherwise be classified as sales-type or direct financing to be classified and accounted for by the lessor as operating leases; provided they meet the criteria listed below. The ASU does not change the measurement or classification guidance in Topic 842, other than this exception for certain sales-type and direct financing leases, but provides the following criteria that must be met for a lessor to classify and account for a sales-type or direct financing lease as an operating lease at lease commencement:
1. The lease would have otherwise been classified as a sales-type or direct financing lease; and
What does CohnReznick Think?
The adoption of this ASU means that a lessor would classify certain leases that meet the criteria described above as operating leases, which would not result in the derecognition of the underlying asset at lease commencement. In addition, since such leases would be classified as operating leases, they may qualify for a practical expedient under Topic 842 regarding leases that include non-lease components. This practical expedient in ASC 842-10-15-42A allows a lessor to make an accounting policy election to not separate non-lease components from its related lease components, by class of underlying asset. The practical expedient is only permitted for operating leases with a non-lease component that would be accounted for under Topic 606 and for which the timing and pattern of transfer of the components (lease component and associated non-lease component) are the same.
Prior to this ASU, the resulting selling loss recognized at lease commencement, as noted above, may not necessarily be indicative of the economics of the transaction. In addition, incurring a commencement date selling loss may make it seem that the underlying asset was impaired prior to lease commencement, even though that may not have been true. At lease commencement, the lessor may have structured the lease to be profitable over the lease term, in contemplation of the variable lease payments that do not depend on a reference index or rate.
The issuance of this ASU better aligns Topic 842 with the economics of transactions meeting the applicable criteria. Since this ASU only applies to lessors, it could result in situations in which a lease is classified as a finance lease by the lessee, but as an operating lease by the lessor.
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