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Lessor Accounting for Certain Leases with Usage-Based Lease Payments

Lessees tend to seek out leases with contractual terms that are the best fit for their operations and complementary to their financing strategies. This, along with the type of equipment subject to lease, should continue to drive lease structures to evolve. This may be observed in the prevalence of usage-based lease payments. Under Topic 842 Leases, usage-based payments that do not depend on a reference index or rate are not included in the measurement of lease payments and are therefore not reflected in a lessee’s related lease liability. Rather, those types of payments are recognized as they are incurred by a lessee and earned by a lessor.

For a lessor, usage-based lease payments in a lease that is otherwise classified as sales-type or direct financing could seemingly result in a disconnect from the underlying economics of the transaction. Specifically, the value of the equipment at lease commencement may exceed the present value of the lease payments measured under Topic 842, indicating a day-one loss in a sales-type or direct financing lease.

To address that disconnect, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update 2021-05, Leases (Topic 842): Lessors — Certain Leases with Variable Lease Payments (the “Update”). The amendments in the Update are operable by lessors, practical to apply and should generally result in an accounting outcome that is attractive to lessors.

Lessor accounting for certain sales-type and direct financing leases with usage-based lease payments
A sales-type or direct financing lease with usage-based lease payments that do not depend on a reference rate or index may result in a commencement date selling loss because the present value of the lease payments, as measured in accordance with Topic 842, may be less than the lessor’s carrying value of the underlying equipment. However, the lessor may have modeled cash flows from usage-based lease payments expected to generate an economic return on the lease of the underlying equipment. To ensure that a lessor’s accounting outcome is faithfully representative of lease economics, the Update amended ASC 842-10 to provide that leases with these characteristics should be classified and accounted for as operating leases by the lessor.

The Financial Accounting Standards Board has issued an update that's generally favorable for lessors.

 

The following criteria must be met for a lessor to classify leases with usage-based lease payments as operating at lease commencement:

  1. The lease would have otherwise been classified as a sales-type or direct financing lease; and
  2. As a result of being classified as sales-type or direct financing, the lessor would have recognized a commencement date selling loss.

Lease classification
A lessor should not attempt to bypass the lease classification criteria in ASC 842-10 for leases with usage-based lease payments. The first criterion discussed above is that the lease is otherwise classified as sales-type or direct financing, which entails the application of the lease classification criteria. The following is a recap of the lease classification guidance (ASC 842-10).

  • A lessor classifies a lease as sales-type if it meets any of the five classification criteria:
    • Lease transfers ownership of the underlying asset to the lessee.
    • Lease grants an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
    • Lease term is for the major part of the remaining economic life of the underlying asset (this criterion does not apply if the commencement date falls at or near the end of the economic life of the underlying asset).
    • The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
    • The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
  • If none of those five classification criteria are met, a lessor will classify a lease as direct financing lease if such lease meets both of the additional classification criteria for lessors (ASC 842-10-25-3b.):
    • The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.
    • It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.
  • A lessor classifies leases that do not meet any of the above lease classification criteria as operating.

Impairment considerations regarding assets underlying leases
A lessor does not derecognize the asset underlying an operating lease. Accordingly, assets underlying operating leases, including equipment underlying operating leases with usage-based payments, are subject to impairment (Accounting Standards Codification Topic 360). The long-lived asset impairment model, in effect, places a constraint on a lessor’s ability to structure sales-type or direct financing leases with inherent economic losses. This is because the long-lived asset impairment model includes a recoverability assessment that is based on expected cash flows from the use and eventual disposal of the underlying asset.

Other considerations
As a result of the amendments in the Update, more leases with usage-based lease payments should be classified as operating. This may allow lessors to apply the practical expedient to combine lease and non-lease components and account for them as a single component. That practical expedient is only permitted for operating leases with non-lease components that would be accounted for in accordance with Topic 606 Revenue from Contracts with Customers and for which the timing and pattern of transfer of the lease and non-lease components are the same.

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  • LEASE ACCOUNTING