16.2 Lessor Accounting

Lessor Accounting under ASC 842

Lessor accounting under ASC 842 is designed to align closely with the lessee accounting model and the revenue recognition principles of ASC 606. From the perspective of the lessor, a lease is classified into one of three categories at commencement: Sales-Type Lease, Direct Financing Lease, or Operating Lease.

Lessor Lease Classification

To classify a lease, the lessor must first evaluate the same five criteria (OWNES) used by lessees:

1. Ownership: Does the lease transfer ownership of the underlying asset to the lessee by the end of the term?
2. Written Option: Does the lease contain a purchase option that the lessee is reasonably certain to exercise?
3. Net Present Value: Does the present value of lease payments and any lessor-guaranteed residual value equal or exceed substantially all (90% or more) of the asset's fair value?
4. Economic Life: Is the lease term for the major part (75% or more) of the asset's remaining economic life?
5. Specialized Asset: Does the asset have no alternative use to the lessor at the end of the lease term?

If the lease meets any one of these five criteria, the lessor must classify the lease as a Sales-Type Lease.

If the lease does not meet any of the OWNES criteria, the lessor must evaluate two additional criteria (the "collection and asset recovery" tests):

• PV & Residual Value: Does the present value of the lease payments plus any residual value guaranteed by the lessee and/or a third party unrelated to the lessor equal or exceed substantially all (90% or more) of the fair value of the underlying asset?
• Collectibility: Is the collection of the lease payments and any amounts necessary to satisfy a residual value guarantee probable?

If both of these additional criteria are met, the lessor must classify the lease as a Direct Financing Lease. If either of these additional criteria is not met, the lease is classified as an Operating Lease.

Residual Values: Guaranteed vs. Unguaranteed

The accounting treatment of residual values plays a critical role in lessor calculations:

• Guaranteed Residual Value: A guarantee made to the lessor that the value of the underlying asset at the end of the lease term will be at least a specified amount. The guarantee can be provided by the lessee (lessee-guaranteed) or a third party unrelated to the lessor.
• Unguaranteed Residual Value: The remaining portion of the estimated residual value of the asset at the end of the lease term that is not guaranteed by the lessee or a third party.
• Net Investment in the Lease: The lessor's Net Investment in the Lease is the sum of:
  • The Lease Receivable: The present value of the lease payments (which includes any lessee-guaranteed residual value).
  • The Unguaranteed Residual Asset: The present value of the unguaranteed residual value.

Accounting for Sales-Type Leases

In a sales-type lease, the lessor effectively sells the underlying asset to the lessee and provides financing. At the lease commencement date:

• Derecognition: The lessor derecognizes the carrying value of the underlying asset from its balance sheet.
• Net Investment in the Lease: The lessor recognizes a new asset called the Net Investment in the Lease. This consists of the Lease Receivable and the Unguaranteed Residual Asset, discounted at the rate implicit in the lease.
• Selling Profit or Loss: The lessor recognizes any selling profit or loss at the commencement date:
  • $\text{Selling Profit/Loss} = \text{Lease Receivable} + \text{Unguaranteed Residual Asset} - \text{Carrying Value of Asset} - \text{Deferred Initial Direct Costs}$
  • If a sales-type lease results in a selling profit, any initial direct costs incurred by the lessor are expensed immediately at commencement. If there is no selling profit (or there is a selling loss), initial direct costs are deferred and amortized over the lease term.
• Subsequent Accounting: The lessor recognizes interest income over the lease term using the effective interest method. The lease receivable is reduced by cash collections (excluding the interest portion).

Accounting for Direct Financing Leases

In a direct financing lease, the lessor does not recognize an immediate selling profit because control of the asset has not transferred to the lessee under the OWNES criteria. However, because the lessor has transferred substantially all of the financial risks/rewards of the asset to the lessee and/or a third-party guarantor, the asset is derecognized.

• Derecognition: The lessor derecognizes the carrying value of the underlying asset.
• Net Investment in the Lease: The lessor records the Net Investment in the Lease, which is equal to the Lease Receivable plus the Unguaranteed Residual Asset, adjusted for any deferred initial direct costs and deferred selling profit.
• Deferred Selling Profit: Any selling profit is deferred at commencement. This deferred profit reduces the carrying amount of the net investment in the lease and is recognized over the lease term as interest income (effectively reducing the rate of return on the lease).
• Selling Loss: Unlike selling profit, a selling loss on a direct financing lease must be recognized immediately at the commencement date.
• Subsequent Accounting: The lessor recognizes interest income over the lease term using the effective interest method.

Accounting for Operating Leases

An operating lease represents a transaction where the lessor retains the risks and rewards of ownership.

• Balance Sheet: The lessor keeps the underlying asset on its balance sheet and continues to depreciate it using its standard depreciation policy.
• Income Statement: The lessor recognizes lease payments as lease income on a straight-line basis over the lease term, regardless of when cash is collected.
• Initial Direct Costs: Initial direct costs incurred by the lessor are deferred and amortized over the lease term on a straight-line basis, matching the recognition of lease income.

Comprehensive Comparison Table

Journal Entry Examples

Let's compare the accounting entries for the lessor.

Example A: Sales-Type Lease

A lessor leases equipment to a lessee on January 1, Year 1:

• Cost of equipment (carrying value): $35,000.
• Fair value of equipment: $50,000.
• Lease payments: $12,000 annually for 5 years, due at the end of each year.
• Implicit rate: 6.43% (present value of payments is $50,000).
• Ownership transfers at the end of the term.

January 1, Year 1 (Commencement):

Debit: Net Investment in Lease (Lease Receivable)  $50,000
   Credit: Equipment                                  $35,000
   Credit: Gain on Sale of Equipment (Selling Profit) $15,000

December 31, Year 1 (First payment):

• Interest Income: $$50,000 \times 6.43% = $3,215$
• Principal Collection: $$12,000 - $3,215 = $8,785$

Debit: Cash                                         $12,000
   Credit: Net Investment in Lease                    $8,785
   Credit: Interest Income                            $3,215

Example B: Operating Lease

Assume the same equipment ($35,000 cost, $5,000 annual depreciation) is leased under a 3-year operating lease with payments of $6,000 per year.

January 1, Year 1 (Commencement): No asset derecognition is recorded. (Only a memo entry is made, or the asset is reclassified from "Equipment" to "Equipment Leased to Others").

December 31, Year 1 (Year-End Entries):

1. Record lease income:

Debit: Cash                                         $6,000
   Credit: Lease Income                               $6,000

1. Record depreciation expense:

Debit: Depreciation Expense                         $5,000
   Credit: Accumulated Depreciation - Leased Asset     $5,000