The terms of a lease arrangement determine how a lease is classified and the resulting income statement recognition. When the terms of a lease effectively transfer control of the underlying asset, the lease represents an in substance financed purchase (sale) of an asset and the lease is classified as a finance lease by the lessee and a sales-type lease by the lessor. When a lease does not effectively transfer control of the underlying asset to the lessee, but the lessor obtains a guarantee for the value of the asset from a third party, the lessor would classify a lease as a direct financing lease. All other leases are classified as operating leases. See LG 7 for information on leveraged leases, a specific model applicable to certain direct financing leases that were entered into before the adoption of ASC 842. While leveraged leases were eliminated under ASC 842, leveraged leases that existed at the adoption of ASC 842 were grandfathered.
Figure LG 3-1 summarizes the accounting by lessees for the different types of leases. Figure LG 3-1Figure LG 3-2 summarizes the accounting by lessors for the different lease types (excluding leveraged leases, which are discussed in LG 7) and Question LG 3-1 discusses how leases between related parties should be classified.
Figure LG 3-2* Under these lease classification criteria, lease arrangements with variable lease payments may be classified by lessors as a sales-type or direct-financing lease. This may lead to the recognition of a selling loss (i.e., a day-one loss) by the lessor even when the overall arrangement is expected to be profitable. In response to concerns raised in the post implementation review, in order to avoid recognition of such day-one loss under ASC 842, the FASB issued ASU 2021-05, Lessors—Certain Leases with Variable Lease Payments, which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on an index or a rate) as an operating lease at the lease commencement date if classifying the lease as a sales-type lease or direct financing lease would result in recognition of a day-one loss. See LG 9.10 for the effective date and transition requirements of ASU 2021-05. See Example LG 4-9 for an illustration of a lease with significant variable payments.
Leases between related parties should be classified like all other leases, as discussed in ASC 842-10-55-12. The classification should be based on the terms of the contract, without adjustment for provisions that may have been impacted by the related party relationship.
Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties.
The lessee and lessor should look only to legally enforceable rights when classifying the lease. In identifying the legally enforceable rights, it would be reasonable to start with a review of the written contract. However, due to the relationship between the two parties, the legal lease provisions in the written contract may be uneconomic or a detailed contract may not exist at all. If this is the case, it would be helpful to involve legal counsel to understand if there are legal rights that exist outside of a written contract. For example, within office space leased from a related party under a nonrenewable, one-year managed service arrangement, a lessee may install leasehold improvements with an economic life of five years. This may indicate that the lessee expects to use the space longer than the one-year lease term and therefore the written contract terms of the arrangement may be considered uneconomic. Furthermore, that may be a reasonable expectation given that management of the lessee and lessor often include the same decision makers. Therefore, in this case it could be helpful to involve legal counsel.
Related party leases are often embedded within other arrangements (e.g., a managed service arrangement). In those cases, the arrangement may include multiple components, including both lease and non-lease components. Therefore, once total contract consideration has been determined based on the legally enforceable rights in the arrangement, it must be allocated between the multiple components in order to determine the appropriate lease payments to be used for lease classification. The total contract consideration is allocated to each component based on relative standalone price for each component. See LG 2.4 for further details on components.
In March 2023, the FASB issued ASU 2023-01, Common Control Arrangements. The guidance provides entities within the scope of ASC 842-10-65-1(b) (that is, entities that are not public business entities, not-for-profit bond obligors, or employee benefit plans that file or furnish financial statements with or to the SEC) a practical expedient to use written terms and conditions for determining whether a lease exists and, if so, the classification and accounting for that lease.
An entity applying the practical expedient would not be required to determine whether those written terms and conditions are legally enforceable. If no written terms and conditions exist, an entity would apply ASC 842 based on the legally enforceable terms of an arrangement. If an entity determines that a lease does not exist, other GAAP would apply. The practical expedient may be applied on an arrangement-by-arrangement basis.
The new guidance is effective for all entities in fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted for both interim and annual financial statements that have not yet been made available for issuance. If an entity adopts the new guidance in an interim period, it should adopt the guidance as of the beginning of the fiscal year that includes that interim period.
Entities adopting the new guidance concurrently with adopting ASC 842 may follow the same transition requirements used to apply ASC 842. All other entities are required to apply the new guidance using one of the following two methods:
Under either adoption method, an entity is permitted to document any existing unwritten terms and conditions of an arrangement between entities under common control before the first date interim or annual financial statements are issued in accordance with this guidance.
When an arrangement previously considered to be a lease continues to be a lease after applying the guidance in this ASU, the entities should account for any changes in the lease resulting from application of the practical expedient as a lease modification. Refer to LG 5 for additional information on accounting for lease modifications.
If an arrangement previously not considered a lease becomes a lease after applying this ASU, an entity should account for the arrangement as a new lease.
The ASU also provides guidance related to accounting for leasehold improvements associated with common control leases. Refer to LG 8.11 for additional information on amortization of leasehold improvements.
ASC 842 requires the determination of whether an arrangement contains a lease at lease inception. Classification and initial measurement of right-of-use assets and lease liabilities are determined at the lease commencement date, which is defined in the ASC 842 Glossary.
Definition from ASC 842 Glossary
Commencement Date of the Lease (Commencement Date): The date on which a lessor makes an underlying asset available for use by a lessee. See paragraphs 842-10-55-19 through 55-21 for implementation guidance on the commencement date.
Right-of-use assets and lease liabilities are not recognized before lease commencement because prior to that date, the lessor has not yet performed under the arrangement. To illustrate, assume a lessee and lessor enter into a lease arrangement on January 1, but the lessor does not make the underlying asset available for use by the lessee until April 1 of the same year. At lease inception (January 1), the arrangement would be assessed to confirm that it contains a lease, but the initial lease classification assessment and measurement of the right-of-use asset and lease liability would occur on April 1.
Although the lease commencement date may be defined in a lease agreement, the accounting assessment should be made on the date that the lessor makes the underlying asset available for use to the lessee. For example, in many real estate leases, a lessee may obtain control over the use of the underlying asset well before it begins to use the leased asset to facilitate the completion of leasehold or other improvements. Determining when a lessor has made the underlying asset available for a lessee’s use is the key to correctly determining the commencement date. Some factors to consider are whether the asset is complete, whether a lessee has the unfettered right to enter the property and the nature of any significant improvement work being performed on the asset. The commencement date specified in the lease contract or the date when lease payments begin are not typically strong indicators of when a lessee has obtained control of the leased asset. For example, if the commencement date per the legal terms of lease agreement for a single floor in an office building has occurred and the lessee has the ability to access the floor, but does not yet control how, when, or whether the space may be used, the lease has not commenced. This could occur when a lessor permits the lessee early access to a property (e.g., to install lessee improvements) while, simultaneously, the lessor continues its own work. The lease has not commenced because the lessor has not relinquished control of the underlying asset to the lessee.
There may be instances when control of the underlying asset has been obtained by a lessee prior to lease commencement (e.g., when a lessee is involved in the construction of the underlying asset). In such cases, the lessee may be required to reflect its control over the asset prior to construction completion. Once construction is completed the lessee should account for the transaction as a sale and leaseback. See LG 6.3.2.6 for additional information.
Although lease classification is determined at the lease commencement date, in certain circumstances a reporting entity may need to reassess classification at a later date. See LG 5.3.