The Financial Accounting Standards Board (FASB) recently issued a standards update intended to improve an area of the new lease guidance related to a lessor’s accounting for certain leases with variable lease payments. This resource provides additional guidance on how the new accounting standard may affect lease accounting for lessors.
Under the new lease accounting rules for sales-type and direct financing leases, as stated in ASC Topic 842, a lessor derecognizes the leased asset, recognizes a net investment in the lease and recognizes selling profit or loss. The initial measurement of the net investment in the lease excludes variable lease payments that are not based on an index or rate, such as those based on the performance or use of the underlying asset. Variable lease payments are becoming more common in sales-type and direct financing leases, particularly in the energy industry, and the exclusion of these payments may result in an initial net investment in the lease that is less than the carrying value of the asset. As a result, lessors may be required to recognize a selling loss at the starting date for a sales-type or direct financing lease with variable payments, even if they expect the arrangement will be profitable overall. When a lessor recognizes a loss on the date of lease commencement for an arrangement that is expected to be profitable, the accounting outcome results in financial reporting that does not represent the underlying economics either at lease commencement or over the lease term.
A Closer Look at the Accounting Change in Action
To illustrate the concept, consider a lease that includes both fixed and variable payments that together are expected to be greater than the carrying value of the underlying asset and, thus, are expected to result in an overall profitable transaction. Assume the lease is determined to be a sales-type lease because ownership transfers at the end of the lease term. If the present value of the fixed payments is less than the carrying value of the underlying asset, the lessor would recognize a day-one loss upon the derecognition of the underlying asset at lease inception. The subsequent recognition of the variable payments results in future accounting profit that is a recovery of the initial day-one loss.
ASU 2021-05: Lessors—Certain Leases with Variable Lease Payments addresses this issue by amending lessor lease classification requirements. A lessor is now required to classify and account for a lease with variable payments that do not depend on a reference index or a rate as an operating lease if:
- The lease would have been classified as a sales-type lease or a direct financing lease; and
- The lessor would have otherwise recognized a day-one loss
A day-one loss or profit is not recognized under operating lease accounting, as the underlying asset is not derecognized. Instead, the variable lease payments are recognized in the period in which the changes in facts and circumstances on which the variable lease payments occur and are offset by the depreciation of the underlying asset. The resulting financial reporting is expected to accurately represent the economics underlying the lease and improve the decision usefulness of information provided to the users of financial statements. This update also results in aligning the accounting under the new guidance in Topic 842 more closely with the practice under the old guidance in Topic 840, in which certain leases with variable payments were accounting for as operating leases by lessors.
The expectation is that more leases will be classified as operating leases under the amendments resulting in more leases qualifying for the lessor practical expedient to not separate lease and associated non-lease components and to account for them as a single component if all requirements are met. Additionally, the amendments may also result in more sale-leaseback transactions for buyer-lessors as a buyer-lessor is not considered to have obtained control of the underlying asset if the leaseback is classified as sales-type lease but is considered to have obtained control if the leaseback is classified as operating or direct financing and the other criteria for sale are met. The amendments will have no impact on the lessee accounting in a sale-leaseback transaction.
Who Is Affected?
The amendments affect lessors with lease contracts that have variable payments that do not depend on a reference index or a rate and would result in a loss if classified as sales-type or direct financing. Leases with variable payments based on an index or rate, for example the consumer price index (CPI) or the prime interest rate, are not impacted by this update.
When Will the Accounting Changes Go Into Effect?
The change is set to take effect for all companies in fiscal years that begin after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 15, 2022. Organizations may incorporate the amendment early, but only if they have already adopted Topic 842. Entities that have not adopted Topic 842 on or before the issuance date of the update should follow the transition requirements of Topic 842 in paragraph 842-10-65-1.
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