The FASB recently issued ASU 2021-05, Leases (Topic 842): Lessors – Certain Leases with Variable Lease Payments. This ASU is the result of the Board’s post-implementation review efforts and feedback received from constituents regarding a specific implementation issue for lessors. Before we review what changed, let’s review the existing framework in ASC 842.

Well, if you want (lessor accounting), then this is what (the FASB) gave you (in 2016)

It is important to understand the scope of ASC 842 and the definition of a lease before reviewing the details of lessor accounting. The definition of a lease is a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. ASC 842 applies to leases of all assets, including sub-leases, except for the following arrangements:

• Leases of intangible assets
• Leases to explore for or use non-regenerative resources
• Leases of biological assets, including timber
• Leases of inventory
• Leases of assets under construction

Our Leases: Overview of ASC 842 course provides a great introduction to the definition of a lease, including several examples!

If a lessor concludes that the arrangement meets the definition of a lease in ASC 842, the lessor must classify the lease as sales-type, direct financing, or operating at the commencement date. This classification is critical because the accounting for each is different. There is a two-part decision tree that helps navigate a lessor to the appropriate classification of a lease arrangement:

Check out this great blog post on classification and initial recognition of leases by lessors. Our Leases: Lessor Accounting Explained course is also a great recourse to learn about the different tests a lessor must analyze when classifying a lease arrangement.

If a lessor concludes that the lease arrangement is either a sales-type or direct financing lease, the lessor must:

1. Derecognize the underlying asset
2. Recognize a net investment in the lease

When the lessor recognizes a net investment in the lease, the existing guidance requires lessors to exclude variable payments, other than those dependent on an index or rate. An example of variable payments would be lease payments that depend on the lessee’s usage rate of the leased asset. ASC 842 requires these variable payments to instead be recognized in the period in which they occur.

Sometimes, the exclusion of variable payments from the initial measurement of the net investment in the lease may result in a lower value than the carrying value of the underlying asset that the lessor must derecognize.

A net investment in the lease that is lower than the carrying value creates a “day one loss” that is recognized immediately by the lessor.

We need a little (less) controversy

Sometimes, lease arrangements include variable payments as a significant component of consideration. In addition, these arrangements may meet the definition of a sales-type or direct financing lease. Under the current guidance in ASC 842, the recognition of a net investment in the lease results in the immediate recognition of a loss. This loss may not fully represent the underlying economics of the transaction, either at lease commencement or during the lease term. In most circumstances, the lessor expects the overall arrangement to be profitable. The recognition of a “day one loss” not only misrepresents the expected outcome of the arrangement, but also results in subsequent margins that were much higher than experienced by the lessor during the lease term.

ASU 2021-05 changes the recognition of these lease arrangements and instead requires the lessor to account for the lease as an operating lease. What does this mean? Instead of derecognizing the underlying asset, the lessor would continue to depreciate the leased asset. In addition, the lessor would recognize variable payments received under the lease arrangement in the period in which there are changes in facts and circumstances on which those variable payments are based occur. The amendments require that the following criteria are met:

1. The lease would have been classified as a sales-type or a direct financing per ASC 842
2. The lessor would have otherwise recognized a “day one loss”

In addition, the leased asset continues to be subject to measurement and impairment requirements under other U.S. GAAP (e.g., ASC 360). Our Impairment: PP&E and Intangible Assets course can walk you through the requirements!

“Testing, attention please”

Let’s illustrate ASU 2021-06 with an example. Shelby Co. enters into an arrangement with Miles Garage Ltd. to lease a piece of Shelby’s engine equipment with the following terms:

• Lease term:                                                8 years
• Remaining useful life of equipment:       9 years
• Lease payments:                                       2% of engines produced using the equipment
• Renewal options:                                      None
• Transfer of ownership:                             No
• Fair value of equipment:                          $75,000
• Carrying value of equipment:                  $65,000
• Estimated residual value:                         $25,000
• Residual value guarantee:                        None

Initial recognition (Prior to ASU 2021-05)

Based on the information provided, Shelby cannot calculate an interest rate implicit on the lease that is greater than zero since the lease term represents a majority (80%) of the equipment’s remaining useful life. Therefore, Shelby would use a 0% discount rate and record the following entry at lease commencement:

Dr. Unguaranteed residual value        25,000

Dr. Selling loss                                       40,000

            Cr. PP&E, equipment                                     65,000

Initial recognition (Upon adoption of ASU 2021-05)

Shelby Co. would still need to analyze the arrangement to determine if the lease should be accounted for under ASC 842. Further, Shelby Co. would still need to consider the two-part decision trees for lessors to determine the appropriate classification of the lease.

If Shelby Co. determined the lease should be classified as sales-type or direct financing, it would still calculate the net investment to determine whether there was any selling profit or loss on the arrangement. Since the arrangement would result in a “day one loss”, Shelby would instead classify the arrangement as an operating lease.

Therefore, there would be no entry recorded at lease commencement for this arrangement.

So, everybody just follow me

For entities that have already adopted ASC 842, this amendment is effective as follows:

• Public business entities: Fiscal years beginning on or after December 15, 2021, including interim periods within those fiscal years
• Other entities: Fiscal years beginning on or after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022

ASU 2021-05 may be applied either retrospectively or prospectively. Early adoption is permitted.

For entities that have yet to adopt ASC 842, this amendment should follow the transition requirements of ASC 842, including the use of the same transition method.

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