In contrast to the lessee model, the lessor model under FASB’s new lease accounting standard has three different types of leases: operating, sales-type, and direct financing. These three types are generally consistent with existing GAAP; a fourth type, leveraged leases, is eliminated by the new guidance. A lessor starts to distinguish the three types of leases by using the same lease classification criteria used by a lessee to determine whether a lease is an operating or finance lease. If any of the five criteria [briefly, 1) ownership is transferred at the end of the lease term; 2) a bargain purchase option for the leased asset exists; 3) the lease term does not commence near the end of, and is primarily for the remaining economic life of, the leased asset; 4) the present value of the lease payments and residual value guarantees is greater than or equal to substantially all of the fair value of the leased asset; or 5) the leased asset has no alternative use to the lessor at the end of the lease term] is met, the lease is evaluated as a sales-type lease.
Assume the following fact pattern:
- Company A leases machinery from Company B on January 1, Year 1.
- The lease period is for 15 years.
- The cost of the machinery is $1,000,000, purchased by the lessor on January 1, Year 1.
- The estimated economic life of the machinery is 15 years.
- The depreciation method is straight line.
- There is no residual value.
- The rate implicit in the lease is 10%.
- The lease payments, due at December 31, are $131,473.
Before completing the accounting, however, the lessor must also consider whether it is probable that it will collect the lease payments, per ASC 842-30-25-3; in such case, lease payments received, including variable payments, must be recognized as a deposit liability until collectability becomes probable, the contract is terminated, or the lessor repossesses the underlying asset. Importantly, the analysis of collectability of the lease payments does not include the ability to repossess the leased asset. Assuming the collection of the lease payments is considered to be probable, the lessor accounts for the sales-type lease as seen in Exhibit 1.
Illustrative Journal Entries for Sales-Type Lease – Lessor
If the lessor cannot establish that collection of the lease payments is probable, even if one of the five criteria is met, the lessor must continue to maintain the underlying asset on its books, record depreciation expense, defer recognition of any initial direct cost (i.e., included in the net investment in the lease), and treat the lease payments as unearned revenue. As soon as the probability of collection is established or the criteria in ASC 842-30-25-3b are met, the lessor must remove the underlying asset from its books, remove the deposit liability recognizing the lease payments as revenue, and record a net investment in the lease for the remaining payments (including any residual guarantees), plus any nonguaranteed portion of the residual value. In order to illustrate the effect of these provisions on lessor accounting, assume the following fact pattern:
- The fair value of the equipment at commencement date is $1,000,000.
- Lease payments are $105,179.
- The carrying value of the equipment is $700,000.
- Total profit at commencement date is $300,000.
- Residual value at end of 15 years is $835,450.
- The lessee guarantees a residual value of $600,000; the remaining $235,450 is unguaranteed.
- Collectibility, including the residual guarantee, is probable.
- Initial direct costs not included in lease payments are $10,000.
- The lease term is 15 years.
- The rate implicit in the lease is 10%.
The accounting is shown in Exhibit 2. Assuming that collectability of lease payments and residual guarantees is not probable, the lessor would nonetheless treat the initial direct costs as a period expense. If the collectibility remains uncertain at end of first year, the lessor would treat receipt of the lease payment as unearned income (i.e., deposit liability) and record depreciation expense on the underlying asset (not derecognized). If, at the end of Year 2, the collectibility provisions have been met, the lessor would derecognize the deposit liability and the carrying value of the underlying asset, and record a net investment in the lease at the present value of the remaining lease payments, the guaranteed residual value, and the present value of the unguaranteed residual value. Exhibit 3 illustrates how the lessor would account for this transaction in the two years following the commencement date, assuming no modifications to the agreement.
Illustrative Journal Entries for Uncollectable Sales-Type Lease at Commencement Date – Lessor
Illustrative Journal Entries for Uncollectable Sales-Type Lease after Commencement Date – Lessor
As a result of this entry, the carrying value of net investment in the lease at the end of Year 1 would be $994,821. The lease receivable result can also be confirmed by taking the interest of $94,364 from the lease payment of $105,179, which amounts to $10,815, representing a recovery of the net investment. Subtracting this amount from the lease receivable at January 1, Year 1 results in a balance of $932,820 at December 31, Year 1. The accreted interest on the residual asset increases its carrying value at December 31, Year 1, to $62,001. At the termination of the lease, this process will increase the residual asset to the amount of unguaranteed residual value of $235,450.
Direct Financing Leases
What is the difference between a sales-type lease and a direct financing lease? If any one of the five criteria of ASC 842-10-25-2 is met, the lessor must classify the lease transaction as a sales-type lease; if none of the criteria is met, the lessor must classify the arrangement as either an operating lease or a direct financing lease. If the present value of the lease payments is less than or equal to the fair value of the asset and collectability of amounts necessary to satisfy the residual value guarantees is probable, the lessor must classify the lease as a direct financing lease.
Lessors should take note of the distinction between ASC 842-10-25-2d and 842-10-25-3b1. Under 842-10-25-2d, a lessor tests whether the present value of the lease payments, which includes residual value guarantees, discounted at the rate implicit in the lease, exceeds the fair value of the asset; if so, it is a sales-type lease. If not, then the lessor must add to the present value a computation of any residual value guarantees related to the lease property provided by a party independent of the lessee and unrelated to the lessor. Because of this third-party requirement, the concept of a direct financing lease is practically eliminated.
In accounting for a direct financing lease, any initial direct cost borne by the lessor must be included in the net investment in the lease. Since these costs are often not included in calculating the lease payments, they must be added to the carrying value of the underlying asset, which requires calculation of new discount rate. Another difference in the accounting treatment of a direct financing lease versus a sales-type lease is that any profit resulting from derecognition of the underlying asset must be deferred. Exhibit 4 illustrates how the lessor accounts for direct financing leases, given the same assumptions underlying Exhibit 3.
Illustrative Journal Entries for Direct Financing Lease – Lessor
Under the standard, the initial direct costs must be deferred and thus included in the net investment in the lease. Given that these costs were not included in the calculation of the payment stream (lease payments and residual value) based on a 10% discount rate, a new discount rate that will provide for an amortization of these payments and the initial direct cost must be computed. The rate that equates the present value of the payment stream with the fair value of the underlying asset, including the initial direct cost, is calculated to be 9.864%. Moreover, the $300,000 profit is deferred and will be recognized in subsequent years as the difference between interest income on the net investment in the lease and the interest income on the sum of the lease receivable and the residual asset.
Before any adjusting entries can be made at year-end, the lessor must compute a new discount rate in order to amortize the components comprising the net investment in the lease. As a result of having to defer recognition of the $300,000 profit, a revised discount rate must be computed, which equates the present value of the lease payments, guaranteed and unguaranteed residual value, and the deferred gross profit with the carrying value of the lease including the initial direct costs. The calculated rate is 15.18%. This leads to the year-end entries shown in Exhibit 4.
The net investment in the lease at the end of Year 1 is determined to be $712,599. The carrying value of net investment in the lease at December 31, Year 1 equals $712,599. On December 31, Year 2, interest will be imputed on the beginning lease receivable of $941,363 and the residual asset of 63,083 at 9.864%, and the portion of deferred gross profit recognized as interest income will be calculated as the difference between interest on the net investment in the lease and the sum of the interest on the lease receivable and the residual asset. An entry based on these amounts similar to the above will be made by lessor for the year ending December 31, Year 2. By the end of the 15-year period, the entire net investment in the lease will have been recovered, and the all of the income on the deferred gross profit will have been recognized.
The journal entries above and in Part 1 illustrate the accounting for the basic lease classifications. Other provisions of the standard address more complicated lease arrangements, such as sale with leasebacks, and leveraged leases. Due to the complexity and detail of provisions governing these leasing arrangements, however, a full discussion is outside the scope of this article.
Changes in Lease Terms
Other provisions of the new standard address whether changes in an original agreement merely modify the existing lease or result in essentially a new lease. In the latter instance, the lessee/lessor must classify the new lease and account for it separately. For example, a lessee and lessor might enter into a 10-year lease for 10,000 square feet of space in a building, and at the beginning of Year 6 decide to modify the existing agreement to provide an additional 5,000 square feet of space for the remaining lease term. If the consideration for the additional space was commensurate with the market price of similar arrangements, this modification would result in a new lease agreement; if it was the consideration below the market price for similar leases, then the modification would result in an extension of the existing lease agreement.
If any modification results in a new lease, the former lease does not require any additional adjustments to either the right-of-use asset or the lease liability. If the modification is viewed as an extension of the original agreement, however, the original lease agreement must be reevaluated and adjusted accordingly, including the right-of-use asset and the lease liability. In such case, the lessee calculates the lease liability at the date of modification based on the changes in the terms and adjusts the lease liability for the difference in the value before and after the change, with the offsetting amount charged or credited to the right-of-use asset. If the change results in new classification (e.g., a change from an operating lease to a finance lease), the lessee calculates the present value of the lease liability based on the remaining payments and adjusts the lease liability for the difference in values before and after the change, with a corresponding increase or decrease in the right-of-use asset. Beginning with the effective date of the modification, the lessee follows the provisions governing the new classification.
Some modifications in lease agreements result in a reduction in the lease term. In some such instances, the change modification can affect the lease liability; in other cases, the right-of-use asset is affected. A reduction related to the lease liability/right-of-use asset will require the lessee to calculate the ratio of the lower present value of the revised payments of the lease liability/right-of-use asset, apply the percentage, and charge the difference to the income statement. If the modification results in the creation of a new right-of-use asset contained within the same contract (i.e., a new lease component), the revised payments created by the modification must be apportioned between the two lease components on a relative basis, based on the stand-alone values of each. Thus, entities will have to examine contracts closely and determine the nature of the modification. The provisions underlying modification might prove to be among the most challenging to implement; companies would be well advised to review the several examples provided by the standard before evaluating the accounting impact of modification on existing lease arrangements.
Given the difficulty and cost inherent in implementing a new standard, FASB provides some relief for companies in what they refer to as “practical expedients.” One example allows the parties in some instances to waive upon transition reassessment of lease contracts and their respective classifications under the new standard. If such a waiver were adopted, the lessee/lessor would not have to reassess expired or existing lease provisions to determine whether the prior agreements meet the new definition of lease contracts, or change existing lease classifications from an operating to a finance lease or vice versa. The lessee/lessor would, however, have to apply the same practical expedient rules to all leasing arrangements of the same class.
A second waiver exists with respect to the treatment of initial direct costs. Regardless of classification, if adopted, the parties would not have to change upon transition their current treatment of these costs for existing leases.
In a third exception from the reassessment provisions upon transition, short-term leases (i.e., less than 12 months) determined prior to transition to be operating leases would not require reassessment or reclassification as operating leases or treatment as finance leases. Again, companies would be required to apply this practical expedient to similar short-term leases. This practical expedient can also be adopted for new leases that have a term less than 12 months, including options to renew a lease that are reasonably certain to be exercised, and do not have an option to purchase the underlying asset that is reasonably certain to be exercised.
Finally, two practical expedients exist that make the lease standard less costly to apply but result in larger lease liabilities. The first is available to nonpublic business entities, which are permitted to use a risk-free interest rate to evaluate lease criteria, as well as in calculating the present value of lease payments for all leases. The second is available to all entities and permits the election to not separate nonlease components from lease components in a lease, and instead treat the entire payment as a lease payment that is present-valued and capitalized. This last election must also be elected and applied to all leases in a class.
How to Prepare for the Transition
Because the transition date is 2019 for public business entities, certain nonprofits, and employee business plans, and 2020 for all other entities, adoption may seem to be a distant prospect; however, all prior periods included in the financial statements of the year of adoption must also be re-presented under the new leasing guidance. If those statements present three years of information, then a company implementing in 2020 will need to have the information it needs to transition its books to the new leasing standard as of January 1, 2018.
For all entities, understanding the impact of adoption sooner rather than later may be critical to future operations. Compliance with covenants-based balance sheet measurements or ratios, such as covenants often contained in long-term debt, will be directly impacted by adoption; therefore, successful planning that allows for consideration of the new guidance will mitigate costs in potentially renegotiating contracts when the standard is adopted. As such, management should already be reviewing its existing lease arrangements, evaluating the likely impact of the standard, and gathering the needed information, as detailed below.
Inventory of contracts.
When taking inventory of their contracts, companies need to create a process to make sure that all contracts that may contain leases are incorporated, whether for large parcels of real estate or small office equipment. One approach would be to ensure that all contracts that are flowing through rent expense currently are included in the listing. Companies also need to be aware of contracts that are not currently accounted for as leases, but may be considered leases under the new standard. In addition, the guidance on related-party leases has changed; under the previous standard, related-party leases are based on the substance of the contract, whereas the new standard bases them on the legally enforceable terms and conditions. Therefore, verbal modification agreements are no longer considered for the lease accounting, and in such cases the recorded assets and liabilities will be higher than if the modification were in writing.
The authors also recommend that companies include key terms and information in contracts, including any covenants that are contained within debt agreements, lease agreements, service contract agreements, and organizational documents. By gathering this information, companies will be able to analyze the impact of the leasing standard on their financial statements and make informed decisions regarding which practical expedients they should elect.
Having to record existing operating leases as right-of-use assets and lease liabilities could lead to a substantial increase in assets and liabilities, which could have a significant impact on certain covenant restrictions; if these are left unaddressed, a company could suddenly be in violation of a covenant upon implementation of the new standard. Covenants based on the balance sheet are expected to have the greatest impact; these include leverage ratios as well as efficiency ratios that are based on total assets. Income statement–based ratios are expected to have less of an impact for lessees; however, these ratios should still be analyzed because of the many potential changes created by the new standard. Lessors face changes to their revenue recognition model, so financial covenants related to the income statement could also be affected. It is imperative that companies understand how their banks read financial statements and how each covenant ratio is defined.
Election of practical expedients.
Once all of the information has been gathered, management will need to assess each of the five practical expedients available and whether they will be elected. There are advantages and drawbacks to each; for example, making the election regarding short-term leases means that the balance sheet is not grossed up to reflect the leases. Companies will, however, have to calculate straight-line rent expense, and may decide against it if they have numerous, large short-term leases, as future obligations may be understated. The election regarding consolidation of lease components saves the company from having to obtain stand-alone prices for services and reduces the time and expense of tracking the accounting for multiple components of a contract, but will result in larger lease liabilities and assets being recorded on the balance sheet. For nonpublic companies, choosing to use the risk-free interest rate will also save companies time (at lease inception) but will result in larger lease liabilities and assets. The final two expedients, regarding impairment of the right-of-use asset and reassessment of contracts, are designed to reduce the cost and complexity of implementing the new standard, but must be elected for all leases.
Systems and controls.
Next, management should create processes and controls to accumulate the necessary information. The controls should include someone reviewing the work of the person who prepares the calculations or inputs information into a software package. In addition, the disclosure requirements are much more extensive in the new standard, meaning companies will need to compile more information about their leases for disclosure. The increased disclosures include qualitative information, such as the significant assumptions and judgments made regarding whether a contract contains a lease, the allocation of contract consideration, and the determination of the discount rate for the lease, and numerous quantitative disclosures, such as breaking lease cost between the various types of leases, calculating a weighted-average remaining lease term and discount rate, and reconciling the maturity analysis of undis-counted lease liabilities by lease type to the balance sheet.
Currently, systems may not be tracking this type of lease information. The following questions should be addressed:
- Is a company’s existing information technology capable of systemizing, organizing, and summarizing the information related to its leasing contracts, including the information needed for disclosures?
- Is the process for tracking commencement dates, changes in lease payments due to escalation clauses, inflation adjustments, lease modifications, and changes in circumstances that make it more likely for the lessee to exercise purchase options or extend lease terms adequate?
- Is the system of internal controls capable of identifying incorrect calculations of present values, misclassification of leases, modifications to the lease, and missing criteria that would have required the company to reassess its lease?
- Is there evidence of a supervisor’s review of the lease accounting, including support for the inputs used?
If a company’s inventory of leases is small, management may be able to track the needed information within a spreadsheet or database. Companies that lease a substantial number of their assets, however, should seriously consider centralizing the information related to their leases, whether in-house using a third-party software package designed to account for leases, or by outsourcing lease management to a global management company.
Finally, as companies work through their processes, they should communicate closely with their auditors to make sure that the needed controls are in place and that the information is tracked in such a way as to create an audit trail of the needed information.
Management should discuss the new standard with the users of its financial statements, even if the dollar impact has not yet been determined. With advance notice, users will have more time to understand the impact and adjust to the change. It is especially important for management to apprise its creditors of the potential impact the new standard might have on existing debt covenants, and possibly work toward modifications or possible renegotiation of debt terms.
The standard will require the CEO, CFO, and other senior management to become more actively involved in the negotiating process, understand the strengths and weaknesses of existing internal controls, and evaluate the costs and benefits of having to upgrade the existing information system. Such involvement is essential given the impact implementing the new standards might have on the appearance of the financial position of the company, its impacts on debt covenants, and the resources that will be needed for the transition. Collaboration among members of the executive management team, information technology personnel, internal auditors, and independent auditors will be essential and require periodic meetings until the standard is adopted. The transition will not be easy, and it is imperative that management have a solid plan.