Carbon Credit Accounting: Considerations for Environmental Credits
ASC 842 and Lessor Accounting: The Adoption Clock Is Ticking
If you surveyed financial leaders on what's top-of-mind these days, lease accounting would probably make the top ten. Maybe top three. But it’s well-warranted given how much of a curveball ASC 842 has thrown at financial organizations and already bleary-eyed accountants, particularly with the adoption deadline for private companies right around the bend.
However, it seems like the bulk of internet-speak around the new lease accounting standard focuses on lessees. So because we don't want lessors to feel left out in the accounting cold, we're taking a look at ASC 842 from a lessor's perspective and what changes the new standard has in store for them.
Changes for Lessors in the Lease Accounting Standards
Thankfully, ASC 842 doesn’t bring any massive, world-altering changes to lessor accounting. Lessors still classify a lease as one of three types:
- Sales-type lease
- Direct financing
- Operating lease
Further, for sales-type and direct financing leases, a lessor will still:
- Recognize their net investment in the lease and derecognize the lease asset on the balance sheet
- Recognize selling profit and interest income on the income statement, where the timing of recognition depends on the lease classification
Likewise, for operating leases, a lesser will still:
- Recognize the underlying lease asset on their balance sheet
- Recognize lease income generally on a straight-line basis over the lease term
That's the good news – lessors aren't looking at nearly the amount of change in the new lease accounting standard as their lessee brethren. However, that's not to say lessors get off completely scot-free.
Differences Between ASC 842 and ASC 840 for Lessors
When it comes to the changes between the old and new lease accounting standards, the fine folks at the Financial Accounting Standards Board (FASB) weren't willy-nilly in their approach. In fact, significant changes to lessor accounting stem from one of three reasons:
- To align the lessor accounting guidance with changes to the lessee accounting guidance
- To align the lessor accounting guidance with concepts introduced under ASC 606, Revenue Recognition
- To improve and/or simplify lessor accounting to remediate a long-standing complexity or absence of guidance under the old lease accounting standard
Put another way, the FASB wanted to make life easier and clearer around lessor accounting. At the same time, it also wanted to ensure both sides of the lease accounting coin – lessors and lessees – meshed with changes to the revenue recognition standard.
Digging in a bit deeper, lessors will find most, but not all, of the changes between the old standard, ASC 840, and the new guidance in ASC 842 revolve around five key specific concepts:
- Lease classification
- Allocation of consideration in a contract
- Initial direct costs
- Variable lease payments
And because we're thorough if we're anything here at Embark, we’re going to dive into each of these concepts to see how they might impact lessor accounting.
1. Lease Classification Considerations
Just as we said up top, lease classification still falls under the same three types – operating, sales-type, and direct financing. However, lease classification now occurs at commencement under the new standard rather than at inception like under ASC 840.
But that said, how does a lessor go about actually classifying a lease in the first place? Well, that comes down to two sets of classification tests, beginning with a set of five tests that are identical to the ones lessees apply under ASC 842:
- Transfer of ownership
- Purchase option
- Lease term (relative to an asset's economic life)
- Lease payment tests
- Specialized asset tests
Collectively, these five tests help lessors determine if they should classify a lease as a sales-type. Specifically, they allow lessors to focus on whether the lease of the non-financial asset is economically similar to the purchase of the non-financial asset by the lessee.
Also, note that, like many of the changes coming to the accounting standards codification, the concept of control is front and center, whereas under ASC 840, the guidance focused more on risks and rewards.
Now, if a sales-type lease fails to meet any of these five initial classification tests, a lessor then shifts to the second set of tests. These focus on whether the risk to the lessor constitutes credit risk, ultimately helping to determine if the lessor has a direct financing or operating lease on its hands through two criteria:
- The lessor effectively converts its risk in the non-financial residual asset to credit risk – i.e., through a residual value guarantee provided by an unrelated third party
- The collectibility of the lease payments – less any amount necessary to satisfy the residual value guarantees provided to the lessor – is probable
When a lease meets both of these criteria, the lessor is looking at a direct financing lease. Otherwise, the lessor classifies it as an operating lease.
Common Areas for Classification Differences under US GAAP
Now that we have a better understanding of lease classification under the new standard, let's look at a few of the most common areas where lessors might expect classification differences between 840 and 842.
Manufacturer Profit or Loss
Remember what we said about control? Instead of differentiating between sales-type and direct financing leases by the presence of manufacturer profit or loss, ASC 842 focuses on whether the lessor:
- Effectively transfers control of the underlying asset to the lessee, or;
- Transfers substantially all of the risks and benefits of ownership of the underlying asset to the lessee and an unrelated third party
Translating that into normal speak – the old leasing standard required a sales-type lease to have an underlying asset where the fair value wasn't equal to its carrying value. Under the new standard, however, no such requirement exists to qualify as a direct financing lease.
This means many leases classified as direct finance under ASC 840 could qualify as sales-type under ASC 842 if they meet any of the classification tests we described.
Collectibility Uncertainties Around Minimum Lease Payments
You had an operating lease under ASC 840 when the collectibility of the minimum lease payments wasn't reasonably predictable. That's not necessarily the case under ASC 842, though, since collectibility uncertainties at lease commencement don't automatically exclude a lease from being a sales-type lease. It does, however, preclude a lease from being a direct financing lease, though.
As a result, what were previously operating leases thanks to collectibility uncertainties might now fall under the sales-type classification.
Real Estate Leases
Under ASC 842, real estate leases no longer have to follow any special set of rules as they did under ASC 840. For example, a real estate lease can now be a sales-type lease, even without a transfer of ownership if it meets any of the other classification tests.
Thus, it's likely more real estate leases could be classified as sales-type or direct financing under the new standard.
Going forward, the concept of a leveraged lease no longer exists from the effective date of the standard. Leases that lessors would have classified as leveraged leases under 840 will now be accounted for differently under 842 as long as they commence on or after the effective date.
However, unless they're subsequently modified, existing leveraged leases are grandfathered in and may continue to apply leveraged lease guidance under ASC 840.
Side Note: Practical Expedients for Lease Classification
Take note, lessors can use the same package of practical expedients as lessees at transition. This includes an expedient that, if elected, lets a lessor avoid reassessing lease classification for any expired or existing leases at transition. In fact, when a business entity elects this package, it must apply it to all of the lease arrangements, whether they're the lessee or lessor.
2. Allocation of Consideration in a Contract
Regarding allocation of consideration under ASC 842, an entity must first identify all of the non-lease and lease components within an arrangement. From there, it measures and allocates the consideration among those non-lease and lease components, accounting for each separately.
Further, allocating consideration under ASC 842 mirrors the transaction price allocation guidance under ASC 606. If you'll recall, the ASC 840 allocation guidance mirrored the multiple element guidance under ASC 605-25.
The complexities of the allocations can vary depending on the circumstances of the lease agreement, especially when you have bundled discounts and variable consideration included under ASC 606.
Practical Expedient for Combining Lease and Non-Lease Components
Like the expedient lessees can elect to combine lease and non-lease components, lessors can make a similar election to streamline things. However, the expedient doesn't necessarily apply to all lessor leases.
Under ASC 842, a lessor can elect to combine non-lease components they would otherwise account for under ASC 606 with the associated lease component as long as it meets two conditions:
- The timing and pattern of transfer for the non-lease component and the associated lease component are the same
- The standalone lease component would be classified as an operating lease if accounted for separately
To qualify for that first condition – the timing and pattern of transfer – a non-lease component must:
- Meet one of the ASC 606 criteria to be satisfied over time rather than at a point in time, and;
- Have a straight-line pattern of transfer to the lessee – i.e., the ASC 606 measure of progress toward satisfaction of the component must be a time elapsed input or output measure
Accounting for a Combined Component
Also, if a lessor elects this practical expedient and, thus, combines non-lease and lease components, the accounting for that combined component depends on additional facts and circumstances.
To flesh out that admittedly vague language, if the non-lease components are more predominant, you account for the whole combined component under ASC 606. Alternatively, if the lease components are more predominant, then it would fall under ASC 842.
But what, exactly, does the FASB mean by predominant? Seems like it requires a fair amount of judgment, right? That's because it does – ASC 842 doesn't include a quantitative test or threshold to determine which component is more predominant.
Instead, the FASB expects most lessors will make that determination qualitatively by answering a few questions, such as:
- How does the customer view the arrangement? In the customer's eyes, is the non-lease component more significant than the lease component?
- As the lessor entity, how are you selling and marketing the arrangement?
- What kinds of costs are you incurring to fulfill these components? Are you incurring greater costs for one component over the other?
Leases With Variable Payments
Now let's say a lessor elects the expedient to combine their components on qualifying leases but those leases have variable payments. In this case, if the non-lease component is more predominant, you account for all variable payments – including variable lease payments – under the new revenue standard.
Alternatively, if the lease component is more predominant, the lessor considers all variable payments for goods or services – again, including variable lease payments – as variable lease payments under ASC 842.
3. Initial Direct Costs
Moving onto the next common area for differences between ASC 840 and ASC 842, the new standard provides a narrower definition for initial direct costs for both lessees and lessors. Under ASC 842, these costs only include the incremental costs of a lease that you would not have incurred if you never executed the lease.
Under the old standard, a lessor would capitalize incremental direct costs to obtain a lease, even if it incurred those costs before obtaining the lease. Therefore, certain costs – like legal fees and allocated internal costs – that a lessor would have capitalized under ASC 840 will now be expensed as incurred under ASC 842.
In a practical sense, this means some lessors will recognize more lease expenses before the lease commences, not to mention higher margins on lease income earned over the lease term. Examples of initial direct costs under ASC 842 include:
- Commissions that are incentive-based
- Regulatory or lease filing fees after lease execution
- Legal fees contingent only on a successful lease
- Lease termination fees for existing tenants
- Consideration paid to third-party for a residual value guarantee
And, yes, there's an expedient package for this transition as well. If elected, a lessor doesn't have to reassess if certain costs previously capitalized as initial direct costs under ASC 840 still qualify under ASC 842 at transition.
We touched on collectibility a bit when walking through classification and how uncertainty doesn't always result in an operating lease anymore. But the concept goes deeper than that for lessors under ASC 842 and, as you're about to see, can be far more problematic under ASC 842 than the old standard.
For sales-type leases, if collectibility is improbable at commencement, a lessor wouldn't recognize any day-one profit or loss. Instead, it defers recognition of the sale until the collectibility of the lease receivable is probable.
Obviously, this requires a lessor to continue monitoring collectibility throughout the lease. This requirement is similar to guidance in ASC 606, where an entity defers revenue if the collectibility of consideration isn't probable.
This isn't just a coincidence, of course, since the FASB wants to make sure sellers of goods can't sidestep the collectibility guidance from ASC 606 by structuring their arrangements as sales-type leases.
Sales-Type Lease With No Sale
Going further down the rabbit hole, if there is no sale to record, the lessor doesn’t derecognize the underlying assets at the lease commencement date. Similarly, it wouldn't recognize a net investment in the lease or any selling profit or loss – other than initial direct costs.
Instead, a lessor records any lease payments it receives as a lease liability – a lessee deposit – until the earlier of when:
- Collectibility becomes probable, or;
- The contract is terminated or completed and the lease payments received are nonrefundable
Also, a lessor should expense initial direct costs associated with the lease at the original commencement date if the fair value of the underlying asset is different from its carrying amount. In the interim, the lessor shouldn't recognize interest expense on the deposit liability but should continue depreciating the underlying asset.
Fast-forwarding to the point where collectibility becomes probable during the lease, a lessor should then derecognize both the underlying asset's carrying amount and the deposit liability from its balance sheet.
Likewise, it would recognize the net investment in the lease on the basis of the remaining lease term and payments using the rate implicit in the lease, along with any selling profit or loss. At that point, the lessor simply follows the subsequent measurement guidance for a sales-type lease.
However, if the collectibility of the lease receivable never becomes probable, the lessor should derecognize the deposit liability with an offset to lease income at termination – assuming the lease payments are nonrefundable.
This is also true in the case of a lessor repossessing the underlying asset, as long as there are no further obligations under the lease contract and the payments are nonrefundable.
Subsequent Changes to Lessee Collectibility Assessment
Let's throw another curveball out there and say that a lessee's creditworthiness falls off a cliff during a sales-type lease contract. Unless the parties modify the lease and do not account for the lease modification as a separate contract, subsequent changes in a lessee’s creditworthiness don't impact the lease classification. That’s so long as everything was kosher with collectibility at the commencement date.
For these types of cases, a lessor accounts for changes in a lessee's credit risk – again, after the commencement date – according to the impairment guidance applicable to the net investment in the lease. This could include using an incurred loss model under ASC 310 or even the CECL framework under ASC 326.
Changes in collectibility also do not impact classification of leases originally determined to be an operating lease. For example, if you have an operating lease at commencement due to collectibility issues, you wouldn’t subsequently reclassify it to a direct financing lease just because collectibility becomes probable later on, after commencement. It’s still an operating lease.
Also, remember that a lease cannot be a direct financing lease if collectibility is uncertain at commencement. In those instances, you classify it as an operating lease.
Speaking of operating leases, the assessment of collectibility over lease payments also impacts a lessor's pattern of revenue recognition for these lease types. If collectibility is probable at commencement, the lessor generally recognizes the lease income on an accrual basis – typically straight-line – over the lease term.
However, if collectibility is not probable for an operating lease, lease income is limited to the lesser of:
- Income the lessor would have recognized if collectibility was probable, or;
- The actual lease payments a lessor collects – i.e., a cash basis
Operating leases also require a lessor to continually monitor collectibility throughout the lease, whether payment collectibility is probable or not at commencement. If collectibility becomes improbable and the cumulative cash receipts are less than the lease income recognized to date, the lessor should reverse the excess lease income.
5. Variable Lease Payments
The last of our five common areas of difference between the old and new lease accounting standard involves variable lease payments. And to begin the topic, it makes sense to review how you account for such payments under ASC 842.
When the FASB issued the new lease standard, a lessor excluded variable lease payments not based on an index or rates from its lease payments. Unfortunately, this resulted in significant day-one losses for lessors with sales-type leases where the lease payments were structured as highly or, in some cases, all-variable lease payments. And as you might guess, lessors didn't think this was too cool.
Therefore, the FASB recently issued Accounting Standards Update (ASU) 2021-05 to address this day-one loss on sales-type leases with variable lease payments, requiring lessors to classify leases with predominantly variable payments as operating leases. This way, the lessor doesn't derecognize the underlying asset or record a day-one loss at commencement.
Instead, depreciation of the underlying asset partially offsets any variable lease revenue earned and recognized in income. The ASU is effective for all calendar year-end entities in 2022, including interim periods within that year for public business entities. Any entity who has already adopted ASC 842 may elect to early adopt the ASU and have the option to apply the amendments either retrospectively or prospectively.
Lessor Disclosure Requirements Under ASC 842
Finally, it wouldn't be one of Embark's tectonic slabs of accounting insights without at least a few words on financial reporting. And as you probably guessed, there's a significant uptick in incremental disclosures for lessors around ASC 842.
This shouldn't come as a surprise, though. Afterall, the intent behind the new standard was to provide financial statement users with more information on risks a lessor is exposed to through leased assets. Likewise, the new standard and accompanying disclosure requirements also provide greater clarity on a lessor's income from leases.
From a qualitative perspective, lessors need to disclose:
- Significant accounting judgments, policy & practical expedient elections, and estimates used in leases
- Information about the nature of leases, such as the nature of variable payment arrangements, and termination, renewal, and purchase options
- Information about how the lessor manages residual asset risk, including details about residual value guarantees and other means of limiting that risk
From a quantitative perspective, lessors need to disclose:
- Maturity analysis of lease receivables for sales-type and direct financing leases, and of lease payments for operating leases
- Selling profit – or loss – recognized at lease commencement, as well as interest income for sales-type and direct financing leases
- Operating lease income
- Variable lease income
We understand all of this can feel overwhelming to a lessor, especially with the private company adoption deadline hovering just over the horizon. But whether you have a metric ton of catching up to do or just want to review the significant progress you've already toward adoption, remember you're not alone. Your lease accounting specialists here at Embark are always ready to jump in and take the baton, no matter what that might mean for you and your specific needs. So let’s chat, shall we?