In the third installment of our series on leases, we take a different perspective on the topic, focusing on the changes lessors face upon implementation of the new standard.
After years of anticipation, we are finally on the doorstep of the adoption of ASC 842, Leases. For most private companies, the overarching question is: “What do I need to know?” The answer depends on which side of the standard you are on. The good news for lessors is that the changes aren’t quite as significant and impactful as they are for lessees. In this post we will cover the big picture of what lessors need to consider regarding the leases standard.
Key Changes to Leases for Lessors
For lessors, ASC 842 represents more of a refinement rather than a remake when it comes to the treatment of leases. To start with, wording in financial statements should now generally replace the word “rent” with “lease” — meaning rent revenue becomes lease revenue, rent term becomes lease term and rent receivable becomes net investment in lease.
Additionally, lessors should be cognizant that the new standard slightly refines the definition of a lease. What previously may have been one lease agreement may now be multiple lease agreements, or, perhaps, not a lease at all. Outside of a few rare exceptions, however, lessors should not anticipate significant changes when it comes to the determination of a lease.
The Exceptions to the Rule for Lessors
Of course, with every new standard’s rules also comes exceptions to those rules. For lessors, there are a handful of such exceptions to be cognizant of, as well as a few specialized revisions, summarized below. If any of these are present in a lease, know that you may need to give additional consideration.
- Real estate leases no longer have unique guidance and follow standard ASC 842 guidelines, just as with any other lease.
- ASC 842 does not include guidance on leveraged leases, which are effectively grandfathered in under legacy guidance, with any new modifications of leveraged leases to be accounted for as a new lease under ASC 842.
- Leases with predominantly variable lease payments may be classified as sales-type or direct financing leases under ASC 842.
- Lease modifications have more guidance on how they are to be treated to better align with ASC 606.
- Initial direct costs, such as legal fees incurred to execute a lease, are generally now expensed under ASC 842 rather than capitalized.
Lease Classification Considerations
The next step for lessors after determining that a lease is in fact present is to determine the type of lease, which then dictates how to further account for (and disclose) the lease.
Under the old standard, leases were generally categorized as operating or capital leases, with capital leases further considered either sales-type or direct financing leases. While this hasn’t changed dramatically for lessors, the qualifications have changed enough to warrant discussion. Gone are the bright line tests involving 75% of economic life and 90% of fair value, and instead more general judgment-based criteria have been introduced, themselves mostly based on the concept of transfer of control rather than risk versus reward.
Under ASC 842, lessors are required to classify a lease as a sales-type lease when any of the following criteria are met:
- Lease transfers ownership of underlying asset to lessee by end of lease term
- Lease grants lessee option to purchase underlying asset that lessee is reasonably certain to exercise
- Lease term is for a major part of the remaining economic life of underlying asset
- Present value of sum of lease payments and any residual value guaranteed by lessee (not already reflected in lease payments) is greater than or equal to substantially all fair value of the underlying asset
- Leased asset is of such a specialized nature that it is expected to have no alternative use to the lessor at end of lease term
Direct Financing Lease
Under ASC 842, lessors are required to classify a lease as a direct financing lease if sales-type lease criteria are not met and when both of the following conditions are met:
- Present value of the sum of lease payments and any residual value guaranteed by the lessee (not already reflected in lease payments) and/or any other third-party payments unrelated to the lessor are greater than or equal to substantially all of the fair value (which is generally cost basis) of the underlying asset
- Probable that the lessor will collect the lease payments plus any amounts necessary to satisfy a residual value guarantee
If the lease doesn’t meet the conditions of either a sales-type lease or a direct financing lease, then that lease is an operating lease. Below is a simple decision tree to help determine lease classification.
Lessor Lease Accounting
You’ve determined you have a lease and what kind of a lease it is. What next? In general, the same thing as before, albeit with slightly different wording as discussed above. Operating leases will see virtually no accounting changes for lessors, a stark contrast to the impact to lessees.
Lessors with sales-type leases will record any selling/leasing profit at lease commencement, whereas those with direct financing leases will gradually recognize this same profit over the course of the lease term. Just as under the previous standard, both sales-type leases and direct financing leases will derecognize the underlying asset and record an “investment in lease” representing the present value of lease payments and any guarantees of estimated asset residual value, as well as the present value of the remaining unguaranteed portion of estimated residual value.
Contact Alex Huth at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.