Accounting Standards Update Affects Certain Leases with Variable Payments

The Financial Accounting Standards Board (FASB) recently released Accounting Standards Update (ASU) 2021-05, which eliminates the requirement for lessors to recognize a day-one loss for certain sales-type or direct financing leases. This ASU amends the lease classification requirements for lessors under Accounting Standards Codification (ASC) 842 to be more consistent with the previous practice under ASC 840.

Prior to the adoption of the ASU, ASC 842 requires a lessor to evaluate specific criteria at lease commencement to determine if a lease should be classified as a sales-type lease or a direct financing lease. In calculating the lease asset under ASC 842, a lessor must exclude variable payments that are not estimated and do not depend on a reference index or a rate.  As a result, the net investment in the lease for a sales-type or a direct financing lease with variable payments may be less than the carrying amount of the underlying asset that is derecognized upon the commencement of the lease.  This results in a day one loss for the lessor even if the lessor expects the lease to be profitable over the lease term.

ASU 2021-05 impacts lessors with lease contracts that (1) have variable lease payments that do not depend on a reference index or a rate and (2) would have resulted in the recognition of a selling loss at lease commencement if classified as sales-type or direct financing.  If the lease which would otherwise be classified as a sales-type or direct financing lease meets these criteria and would result in a day-one loss, ASU 2021-05 requires lessors to classify the lease as an operating lease.

As an operating lease, the lessor does not recognize a net investment or derecognize the underlying asset. As a result, the lessor does not recognize a profit or loss under ASU 2021-05.

ASU 2021-05 also has different effective dates for public business entities and all other entities. This ASU is effective for all entities fiscal years beginning after December 15, 2021.  For public business entities, it is effective for interim periods within fiscal years beginning after December 15, 2021.For all other entities, it is effective for interim periods within fiscal years beginning after December 15, 2022. Early adoption is permitted, but not before adopting ASC 842.

Entities that have not yet adopted ASC 842 before the issuance of ASU 2021-05 can choose to either:

• Adopt the ASU retrospectively to each prior period presented in the financial statements, with a cumulative effect adjustment recognized in the earliest period presented, or
• Adopt the ASU retrospectively to the beginning of the period of adoption, with a cumulative effect adjustment recognized at the beginning of the period of adoption.

Entities that have adopted Topic 842 prior to the issuance date of ASU 2021-05 can choose to either (i) apply the ASU retrospectively to leases that commenced or were modified after adoption of ASC 842, or, (ii) prospectively to leases that commenced or were modified after the entity adopts the ASU.

For information about accounting for leases under ASU 2021-05, contact us. We are here to help.

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