Lessor Capital Lease Accounting: What’s Changed?

In an agreement to use an asset, the lessor is the entity that owns the asset and grants the right to use it to a lessee in exchange for payment. The accounting rules for these transactions have changed significantly under the current standard, ASC 842. The term “capital lease” from the old standard, ASC 840, has been replaced, and these leases are now called “finance leases.”

This shift in terminology reflects a change from a model focused on risks and rewards to one based on control of the asset. While the name has changed, the idea of a lease that transfers control of an asset remains. This article explains the accounting framework for lessors under ASC 842 for arrangements formerly known as capital leases.

Lease Classification Criteria for Lessors

Under ASC 842, a lessor must evaluate every lease at its commencement date to determine its classification. If the lease meets any one of five specific criteria, it is classified as a finance lease. This classification is important because it dictates the subsequent accounting treatment.

The first criterion is a transfer of ownership of the asset to the lessee by the end of the lease term. The second is met if the lease contains a purchase option that the lessee is reasonably certain to exercise, often because the price is a significant discount to the asset’s expected fair value.

A lease is also a finance lease if the term constitutes a major part of the asset’s remaining economic life; 75% or more is a common benchmark. The fourth criterion is met if the present value of the lease payments equals or exceeds substantially all of the asset’s fair value, for which a 90% benchmark is often used.

The final criterion considers whether the asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term. An example is machinery custom-built for a lessee’s unique manufacturing process that cannot be easily repurposed.

Accounting for Sales-Type Leases

A finance lease is further classified as either a sales-type or a direct financing lease. A sales-type lease involves recognizing a selling profit or loss at commencement, effectively treating the transaction as a sale of the asset. This is the most common classification for finance leases.

At the start of a sales-type lease, the lessor removes the leased asset from its balance sheet, an action known as derecognition, and records a “net investment in the lease.” This new asset is composed of the present value of the lease payments and the present value of the asset’s unguaranteed residual value.

For instance, if a lessor leases an asset with a carrying value of $80,000 and a fair value of $100,000, it recognizes the transaction as a sale. The journal entry would involve debiting Net Investment in the Lease for $100,000, crediting the Leased Asset for $80,000, and crediting Sales Revenue for $100,000. A corresponding entry would debit Cost of Goods Sold for $80,000, resulting in an immediate gross profit of $20,000.

Subsequent accounting involves tracking payments from the lessee. Each payment is allocated between interest income and a reduction of the principal balance of the net investment in the lease. This allocation is performed using the effective interest method, which ensures a constant rate of return on the net investment over the lease term.

If the lessor receives a lease payment of $15,000, and the calculated interest for the period is $4,000, the journal entry would be a debit to Cash for $15,000. The credits would be to Interest Income for $4,000 and to Net Investment in the Lease for the remaining $11,000.

Accounting for Direct Financing Leases

A finance lease that is not a sales-type lease is classified as a direct financing lease. The distinction is the timing of profit recognition; the lessor does not recognize selling profit at commencement. Instead, all income is recognized over the lease term as interest income, which occurs when the asset’s fair value equals its carrying amount.

The initial accounting derecognizes the underlying asset and recognizes a net investment in the lease, but without entries for sales revenue or cost of goods sold. For an asset with a carrying amount of $100,000, the entry would be a debit to Net Investment in the Lease for $100,000 and a credit to the Leased Asset for $100,000.

A notable difference involves initial direct costs, like commissions or legal fees. For a direct financing lease, these costs are not expensed immediately but are added to the net investment in the lease. They are then amortized over the lease term as an adjustment to the interest income.

The subsequent measurement for a direct financing lease mirrors that of a sales-type lease. As the lessor receives payments, each is allocated between interest income and a reduction of the net investment in the lease. The interest income is calculated using the rate that allocates the total profit over the lease term.

For example, a cash payment of $12,000 would be recorded with a debit to Cash. The corresponding credits would be to Interest Income for the calculated amount for the period (e.g., $4,500) and to Net Investment in the Lease for the remainder ($7,500).

Required Financial Statement Disclosures

Beyond the accounting entries, ASC 842 mandates that lessors provide comprehensive disclosures in their financial statements. The objective is to give users a clear picture of the amount, timing, and uncertainty of cash flows from lease agreements. These disclosures include both qualitative and quantitative data.

Qualitative disclosures require the lessor to describe the general nature of its lease agreements. This includes explaining how variable lease payments are determined and providing insight into significant assumptions and judgments made. For example, a lessor would disclose information about how it manages risk associated with the residual value of its leased assets.

The quantitative disclosures are more specific and often require a tabular format for clarity. Lessors must disclose the finance lease income recognized during the period, separating the selling profit or loss from the interest income earned over time. They must also report any income from variable lease payments not included in the initial lease receivable.

A maturity analysis of the lessor’s lease receivables is also required. This schedule must show the undiscounted cash flows the lessor expects to receive for each of the first five years after the reporting date. A final, single amount must be disclosed for all the remaining years thereafter.