ASC 842 Lessor Accounting: Sales-Type, Direct Financing, and Operating Leases

Lessor Accounting Under ASC 842

While ASC 842 made dramatic changes to lessee accounting, lessor accounting remained largely consistent with prior guidance under ASC 840. Lessors classify leases into three categories: sales-type, direct financing, and operating. The classification determines when and how the lessor recognizes revenue and derecognizes the underlying asset. The CPA FAR exam tests lessor accounting through both multiple-choice questions and task-based simulations.

Lessor Lease Classification

A lessor classifies a lease as a sales-type lease if any one of the same five criteria used by lessees is met: ownership transfer, purchase option reasonably certain to be exercised, major part of economic life, present value of lease payments substantially all of fair value, or specialized asset with no alternative use. These criteria indicate that the lessor has effectively transferred substantially all the risks and rewards of ownership.

If none of the five criteria is met, the lessor classifies the lease as a direct financing lease if both of the following conditions are met: the present value of the lease payments plus any residual value guaranteed by the lessee or a third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset, and it is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

If neither the sales-type nor direct financing classification criteria are met, the lease is classified as an operating lease.

Sales-Type Lease Accounting

At lease commencement, a lessor in a sales-type lease derecognizes the underlying asset and recognizes a net investment in the lease. The lessor also recognizes selling profit or loss. The net investment in the lease consists of the lease receivable (present value of lease payments not yet received plus the present value of any unguaranteed residual asset) minus any deferred selling profit if collectibility is not probable.

Journal Entry at Commencement

The lessor debits the lease receivable for the present value of lease payments plus guaranteed residual value, debits an unguaranteed residual asset for the present value of the unguaranteed residual, credits the underlying asset at its carrying amount, and recognizes any difference as selling profit or loss. If initial direct costs are incurred and there is selling profit, those costs are expensed at commencement. If there is no selling profit, initial direct costs are included in the net investment measurement.

Subsequent Measurement

The lessor recognizes interest income on the net investment in the lease using the effective interest method. Each lease payment received reduces the lease receivable. The lessor also evaluates the net investment for impairment under the credit loss guidance in ASC 326.

Direct Financing Lease Accounting

A direct financing lease is similar to a sales-type lease in that the lessor derecognizes the underlying asset and recognizes a net investment. However, any selling profit is deferred at commencement and recognized over the lease term as part of interest income. A selling loss, if any, is recognized immediately. Initial direct costs are included in the net investment and effectively reduce the yield that the lessor recognizes as interest income over the lease term.

The net investment in a direct financing lease equals the lease receivable plus the unguaranteed residual asset, adjusted for deferred selling profit and initial direct costs. Interest income is recognized using the rate that, when applied to the net investment, produces a constant periodic rate of return.

Operating Lease Accounting

For an operating lease, the lessor retains the underlying asset on its balance sheet and continues to depreciate it. Lease income is recognized on a straight-line basis over the lease term, even if the payment schedule is not straight-line. Initial direct costs are capitalized as part of the carrying amount of the underlying asset and amortized over the lease term on the same basis as lease income.

Variable lease payments that do not depend on an index or rate are recognized as income in the period in which the changes in facts and circumstances on which the variable payments are based occur. The underlying asset is evaluated for impairment under ASC 360.

Collectibility Considerations

For sales-type and direct financing leases, if it is not probable at commencement that the lessor will collect the lease payments, the lessor does not derecognize the underlying asset, does not recognize a net investment, and continues to recognize lease payments received as a deposit liability until the lease is terminated or collectibility becomes probable.

Lessor Disclosures

Lessors must disclose information about the nature of their leasing activities, significant assumptions and judgments, amounts recognized in the financial statements (lease income by category, interest income on net investments, and variable lease income), and a maturity analysis of lease receivables and operating lease payments.

Exam Preparation Tips

• Understand the hierarchy: first test the five criteria for sales-type classification, then the two additional criteria for direct financing, and if neither is met, classify as operating.
• Know the key difference between sales-type and direct financing: selling profit recognition at commencement vs. deferral over the lease term.
• Practice building amortization schedules for the net investment in sales-type and direct financing leases.
• Remember that operating lease lessors keep the asset on their books and recognize straight-line income.
• Be prepared for questions about collectibility and when the lessor should not derecognize the underlying asset.