New Leases Standard – What Do Lessors Need To Know – Finance and Banking

In 2016, the Financial Accounting Standards Board (FASB) issued
Accounting Standards Update 2016-02 Leases (Topic 842),
otherwise known as “the new leases standard.” The
standard was the culmination of a decade-long project aimed at
achieving greater financial transparency of off-balance sheet
liabilities. Because the goal was to shine a light on previously
unrecognized commitments, the common misconception is that the new
leases standard will have little to no impact on lessors. The
reality is that the new standard could have a significant impact on
the lessor’s financial reporting. The good news is that, for
private companies, there is still time to prepare.

New Lease Classifications Under Topic 842

Under Topic 842, leases are reported as either sales-type,
direct financing or operating leases, depending on specific
criteria. The criteria for a sales-type lease is generally the same
as the criteria for a capital lease under the extant (old) lease
standard. If the criteria for a sales-type lease is not met, then
the lease is evaluated against two additional criteria to determine
if it meets the classification of a direct financing lease. If the
lease does not meet the criteria for a sales-type or direct
financing lease, then the lease is classified as an operating
lease.

Because sales-type leases under Topic 842 have very similar
criteria as capital leases under the old lease standard, and
operating leases under both Topic 842 and the old lease standard
are the “if all criteria not met” classification, the
primary difference in classification is the new direct financing
lease classification.

Lease Measurement Under Topic 842

For lessors, the most significant challenge of the new lease
standard is the change in the calculation of the lessor’s
investment in the sales-type (capital leases under the old lease
standard) or direct financing lease. The accounting for operating
leases under Topic 842 is consistent with the old lease
standard.

Under the old lease standard, the investment in the capital
lease was recorded at the sum of the future minimum lease payments
at the lease inception date. Under Topic 842, the investment in a
sales-type or direct financing lease is recorded at the present
value of the lease receivable, which is the future minimum lease
payments discounted at the rate implicit in the lease at the lease
commencement date.

The primary difference here is that the initial calculation
under Topic 842 requires the initial investment to be recorded at
present value of the lease payments, instead of at actual
(undiscounted) lease payments as was the case under the old lease
standard. This may result in the investment in the lease being
recorded at a much lower initial amount than the investment in the
lease would have been recorded under the old standard.

Additionally, under the old lease standard the carrying value of
the leased asset is written down over the life of the lease. Under
Topic 842, the leased asset is no longer carried on the
lessor’s books over the life of the lease. At the lease
commencement date, the carrying value of the leased asset is
written off and a selling profit or loss is recognized for the
difference between the carrying value of the leased asset and lease
receivable. For sales-type leases, the selling profit or loss is
recognized at the lease commencement date. For direct financing
leases, if there is a selling loss, then it is recognized at the
lease commencement date. However, if there is a selling profit,
then the profit is recognized over the life of the lease.

Because the leased asset is written off at an earlier date
(lease commencement date) and the lease receivable is discounted to
present value, there is a likelihood that some lessors will
recognize a selling loss at inception of a lease that may actually
be profitable over the life of the lease.

Effective Dates of Topic 842

The effective date of Topic 842 depends on what type of entity
is involved. In June 2020, as a result of the COVID-19 pandemic,
FASB delayed the effective date for certain entities who had not
yet adopted Topic 842.

The following table shows the effective dates by entity
type:

Planning for Adoption of Topic 842

Categorize your leases into the new classifications: Sales-type,
direct financing or operating. This may require some judgment since
the criteria for each classification are not as clear cut as under
the old lease standard. Once the lease classifications are
identified, you can then start quantifying the impact of Topic 842
on your entity’s financial statements, including the notes, and
assessing if any of the changes should be communicated to the users
of your financial statements.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.