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. 

Related Read: Topic 842 Basics for Lessees

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.

For more information contact Kelly Buchheit at [email protected], or call her at 312.670.7444.