What’s Changing With Lessor Accounting?

The New Leasing Standard, Lessors and the Puzzle of Lease and Non-Lease Components

When Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842) was issued in February 2016 the often-repeated headline was that lessor accounting would not change under the new standard. While the broad lessor models did not change, there are indeed several changes that will impact how a lessor accounts for a lease.

One change that is receiving attention is the accounting for costs paid directly by the lessee that are an obligation of or, in the words of the model, benefit the lessor. Recent interpretations of the standard have drawn attention to the requirement that lessors record income and expense for these costs even if the lessor is not paying them directly. This is a significant shift from current practice. It is hoped this summary will help you correctly apply the new standard.

What’s Different?

Lease accounting under SFAS 13/ASC 840 included concepts that were applied when separating lease elements from any substantial services bundled with the lease. Only the lease element was subject to lease accounting, and the lease components were dealt with in a set manner. Rental payments, executory costs and minimum lease payments are all significant parts of this puzzle.

Taken together, lease accounting in ASC 840 worked in the following manner:

• Lease and substantial service elements were separated, and payments and other considerations in the arrangement were allocated to those elements on a relative fair value basis; and

• Those amounts within lease accounting that were not part of minimum lease payments, such as executory costs like property taxes, insurance and maintenance, were removed from minimum lease payments and lease accounting using a residual approach, subtracting them so that the remainder is subject to lease accounting.

ASC 842 takes a different path. It takes all the payments a lessee makes to the lessor and allocates them to the lease and non-lease components based on their relative standalone selling prices—using the guidance in the new revenue recognition standard (ASC 606). “Components” are only items that transfer a good or provide a service to the lessee.

Under this approach the former executory costs related to property tax and insurance are not components, and payments of those costs by the lessee are allocated to the lease and non-lease components; for leases without non-lease components—entirely to the lease. The rationale behind this approach is those payments are no different than other contractual payments where the lessee is paying for costs that reimburse the lessor for costs they are obligated to or benefit the lessor.

For more information on lease and non-lease components, please review the series of Financial Watch articles on the new lease accounting standards published in 2016 at www.elfaonline.org/LeaseAccountingTools.

In a lease the lessor may pay property taxes and insurance directly. Then the business would bill the lessee for the items or include them into their rent payment without itemizing it. Alternatively, the lessee may pay these taxes and insurance directly.

The ELFA Financial Accounting Committee is committed to helping businesses complete their own lease accounting puzzle. As we get closer to the official adoption date—Jan. 1, 2019 for most companies—look out for further information, guides and discussions.

Under today’s ASC 840 there is no accounting required for these items in the lessor’s financial statements because the costs and lessee’s payments are recorded on a net basis. However, when the new standard is adopted, the lessor will need to account for these items on a gross basis, and record income and expenses related to the lessee’s paid costs for all leases that start on or after the effective adoption date. The lessor’s accounting would then mirror the lessee’s. If the lessor had an operating lease the entry to recognize the lessee paid costs might be Dr. Insurance Expense, Cr. Lease Revenues. In the case of a sales-type or direct financing lease, the accounting might be more complex as indicated below.

This represents a significant change from current practices, and it has been the subject of a lot of discussion over the past six months. FASB staff confirmed this is the correct way to interpret the standard.

Practice Questions and Issues

The operational aspects of this new accounting standard are complex and should not be minimized. You may even have a few questions, such as:

• Insurance: Which costs incurred by the lessee should be subject to this accounting presentation? When considering insurance, is it an appropriate question to ask if insurance directly benefits the lessor or if it covers the lessee’s asset-related risks during the term of the lease? Your response may impact the answer. How do practical measurement issues impact the accounting? For example, a lessee may add a leased asset to their policy with little to no change to the premium. In that case, what amount would the lessor consider accounting for?
  
  
• Taxes: Which taxes are subject to the accounting practices and under what conditions? The asset may or not be subject to property tax or it may be subject to another form of asset tax that is the responsibility of the party using the asset.
  
  
• Costs: How will the lease model accommodate these costs? While these costs appear to be variable lease payments and not part of lease payments for classification and booking purposes, they may not always be. If the lease was a sales type or direct finance lease this will complicate the lessor’s accounting for its investment in the lease.

In addition to these questions, there are other operational issues a lessor may encounter, including:

• How will the lessor obtain this information from the lessee?
• Is the lessor entitled to receive this information?
• What support would the lessor need for the amount? Would the lessor be able to obtain it?
• Does the lessor’s accounting system accommodate these data and is it programmed to account for them?

The operational aspects of this accounting practice should not be minimized. Given the nature of lease portfolios, applying this accounting to large numbers of transactions is likely to be a challenge.

Next Steps

This is the approach set forth in the new standard. The ELFA Financial Accounting Committee is committed to helping businesses complete their own lease accounting puzzle. As we get closer to the official adoption date—Jan. 1, 2019 for most companies—look out for further information, guides and discussions. In the meantime, visit ELFA’s Lease Accounting page at www.elfaonline.org/LeaseAccountingTools or the FASB’s Implementing New Standards page at http://bit.ly/2rV7R9s.