The Financial Accounting Standards Board (FASB) issued an update to Accounting Standards Codification (ASC) 842, Leases. The updated Accounting Standards Update (ASU) 2021-05, Lessors – Certain Leases with Variable Lease Payments, was issued on July 19, 2021.
What type of lease contract does this apply to?
ASU 2021-05 updates certain guidance in ASC 842, Leases, to make targeted improvements to accounting for certain sales-type and direct financing leases with variable payments. It is applicable to all entities other than public business entities for fiscal years beginning after December 15, 2022. Early adoption is permitted.
ASC 842 requires a lessor to go through the determination of whether a lease is required to be classified as a financing lease at the commencement of the lease based on facts and circumstances of that lease. Lessors were not allowed to estimate certain variable payments and were required to exclude variable payments that were not estimated and didn’t depend on a reference index or rate from the lease receivable. An example of a variable payment in a lease would be payments based on future sales or purchase commitments thresholds,
Any excluded variable payments were originally required to be recorded when received under ASU 2016-02 (Leases). Therefore, certain lessors with variable lease payments in financing type leases were required to recognize a loss at lease commencement (i.e. a day-one loss) regardless of whether the lessor expected the arrangement to be profitable in aggregate.
Why did FASB make the revision?
The FASB came to the conclusion that recognizing a day-one loss for these sales-type leases did not represent the overall economics of the lease either at the commencement or over the entire lease term. Under legacy generally accepted accounting principles (ASC 840), lessors were not required to recognize a day-one loss due to the accounting requirement to account for leases with substantial variable payments as operating leases based on ASC 840’s classification requirements. This classification requirement was not retained under ASC 842.
If a lease meets the criteria under ASC 842 for classification as either a financing lease and application of the financing lease recognition guidance would result in recognition of a day-one loss, then the ASU 2021-05 requires the lessor to classify the lease as an operating lease.
What has changed?
As such, with the release of ASU 2021-05, lessors are required to classify a lease with variable lease payments that do not depend on an index or rate as an operating lease at commencement if both of the following conditions are satisfied:
- The lease would have been classified as a sales-type lease or direct financing lease under ASC 842
- The lessor would have otherwise recognized a day-one loss
What are our options if we have already adopted ASC 842?
Companies who have adopted ASC 842 before the issuance date of ASU 2021-05 have the option to apply the amendments of this update as follows:
- Applied retrospectively to leases that commenced or were modified on or after the adoption of ASU 842. Entities that apply the retrospective transition method must disclose certain facts and circumstances around the retrospective adjustment. The cumulative effect of applying the amendment in ASU 2021-05 is adjusted through retained earnings and is to be disclosed as of the earlier of the date of the earliest period presented or when ASC 842 was adopted.
- Applied prospectively to leases that commence or are modified on or after the date that an entity first applies the amendments.
Our Windham Brannon assurance teams are staying on top of the latest accounting standards. Should your business need help adopting and implementing ASU 2021-05 and/or ASC 842, contact Bobby Vercoe or your Windham Brannon advisor.