Most ASC 842 coverage is written for lessees. Yet a dealer that finances equipment sales through leases, or an equipment owner that rents on long terms, sits on the other side of the standard. A lessor that keeps booking every lease as rent income may be reporting revenue, cost of sales and interest in the wrong places, and may be missing a credit loss allowance on a financial asset.
This guide covers how a lessor decides between sales-type, direct financing and operating treatment, what the net investment is, how selling profit behaves, and what an auditor tests. Rent-based real estate lessors are covered in /us/blog/real-estate-lessor-revenue-straight-line-rent-asc-842-audit.
How does a lessor classify a lease?
Classification starts with the same tests lessees use. If any one of the five criteria in the classification paragraph is met, the lessor classifies the lease as sales-type. The criteria cover transfer of ownership by the end of the term, a purchase option the lessee is reasonably certain to exercise, a lease term that covers a major part of the asset's remaining economic life, present value of payments that substantially equals fair value, and an asset so specialized that it has no alternative use to the lessor at the end of the term. ASC 842 does not require bright lines. One approach reads "major part" as 75 percent or more of remaining economic life and "substantially all" as 90 percent or more of fair value.
If no sales-type criterion is met, the lessor tests for direct financing. The present value of the lease payments plus any residual value guaranteed by the lessee or by an unrelated third party must equal or exceed substantially all of the asset's fair value, and collection of the payments must be probable. A third-party residual value guarantee can therefore push a lease into direct financing while the lessee, which ignores that guarantee, classifies the same lease as operating.
Every other lease is operating for the lessor.
Two overrides sit on top of these tests:
- Variable payments and a day-one loss. If a sales-type or direct financing classification would produce a selling loss at commencement because the payments are variable and do not depend on an index or rate, the lease is operating.
- Collectibility. If collection of the lease payments is not probable, a lease that otherwise qualifies as direct financing is operating. A sales-type lease is still classified as sales-type, but the lessor does not derecognize the asset. It records payments received as a deposit liability until collectibility becomes probable or the contract ends.
What is the net investment?
The net investment in a sales-type lease is the lease receivable plus the unguaranteed residual asset. The lease receivable is the present value of lease payments not yet received, plus amounts guaranteed by the lessee or an unrelated third party, discounted at the rate implicit in the lease. The unguaranteed residual asset is the present value of the residual value the lessor expects to recover that no one guarantees. There is none when the lessee keeps the asset, as with a reasonably certain purchase option.
Selling profit is the fair value of the asset (or the lease receivable plus any prepaid payments, if lower), minus the carrying amount net of the unguaranteed residual. Revenue is the lease receivable plus upfront payments. Cost of sales is the carrying amount less the unguaranteed residual. Initial direct costs follow their own rules and are left out of the illustrations below.
Worked entries
All figures are illustrations. A dealer leases equipment with a fair value of $100,000 and a carrying amount of $80,000. The lease runs five years with $22,000 payable at the end of each year, and the dealer expects an unguaranteed residual of $10,000. The rate implicit in the lease is 6.0504 percent (6.05 percent rounded). The lessee does not guarantee the residual and no third party does.
Sales-type lease at commencement
The lease receivable is $92,545 and the unguaranteed residual asset is $7,455. Selling profit is the $92,545 receivable minus the $72,545 carrying amount net of the residual ($80,000 less $7,455), or $20,000.
| Account | Debit | Credit |
|---|---|---|
| Lease receivable | 92,545 | |
| Unguaranteed residual asset | 7,455 | |
| Cost of sales | 72,545 | |
| Equipment | 80,000 | |
| Revenue | 92,545 |
Debits and credits both total $172,545. Revenue less cost of sales is the $20,000 profit, recognized at commencement.
Year one
Interest income is the net investment of $100,000 times 6.05 percent, or $6,050. The first payment is $22,000.
| Account | Debit | Credit |
|---|---|---|
| Cash | 22,000 | |
| Interest income | 6,050 | |
| Net investment in lease | 15,950 |
The net investment falls from $100,000 to $84,050. In year two, interest is $5,085 and the net investment falls to $67,136.
A direct financing lease
Change the terms. The equipment has a fair value of $100,000 and a carrying amount of $80,000. The lease runs five years with $19,000 payable at the end of each year, and an unrelated third party guarantees a $20,000 residual at the end of the term. Assume the equipment's economic life is 10 years, there is no transfer of title or purchase option, and the asset is not specialized. The rate implicit in the lease is 4.33 percent.
The present value of the payments is $83,816, which is 84 percent of fair value, so no sales-type criterion is met. The present value of the guarantee is $16,184. The two together are $100,000, at least 90 percent of fair value, and collection is probable, so the lease is direct financing. The lessee ignores the third-party guarantee and classifies the lease as operating.
The net investment is the $100,000 receivable less the $20,000 selling profit, which is deferred, or $80,000. The lessor derecognizes the equipment and recognizes no profit at commencement.
| Account | Debit | Credit |
|---|---|---|
| Net investment in lease ($100,000 receivable less $20,000 deferred profit) | 80,000 | |
| Equipment | 80,000 |
The deferred selling profit and any initial direct costs are included in the net investment and come into income over the term as interest income, which produces a constant periodic return. A selling loss is not deferred.
When a day-one loss forces operating treatment
Take equipment with a $100,000 fair value and an $80,000 carrying amount, leased for five years at a price per use that is variable and does not depend on an index or rate. Almost none of the consideration is fixed, so sales-type or direct financing accounting would record a selling loss at commencement. The lease is operating, the equipment stays on the books and is depreciated, and no lease entry is made at commencement.
How are credit losses and operating leases treated?
The net investment in a sales-type or direct financing lease is a financial asset. The current expected credit loss model applies, and an allowance is recorded when the receivable is recognized. Losses can be measured on a pool basis for leases with similar risk characteristics. See /us/blog/cecl-asc-326-private-companies.
For operating leases, the underlying asset is property and equipment and follows impairment guidance for long-lived assets. Operating lease receivables are outside the credit loss model.
Audit angle
- Classification memo. Obtain the lessor's analysis against each criterion, the discount rate, and the treatment of renewal and purchase options. Recompute the present value test.
- Rate and receivable. Recompute the implicit rate and the opening receivable from the contract. Initial direct costs enter the rate in a direct financing lease.
- Residual value. Obtain support for the unguaranteed residual, and check that no third-party guarantee is being counted without a contract.
- Selling profit. Agree revenue, cost of sales and profit to the commencement entry. For direct financing, check that no profit was taken at commencement.
- Net investment rollforward. Recompute interest income and agree cash receipts to the bank.
- Allowance. Test the credit loss estimate and the pooling.
- Disclosure. Agree the lease income, selling profit and net investment disclosures to the schedules.
- Variable payments. Check that no lease with a day-one loss is classified as sales-type or direct financing.
Common misstatements: recording all leases as operating income, recognizing profit at commencement on a direct financing lease, omitting the allowance, and counting variable payments in the receivable.
Lease modifications and elections are covered in /us/blog/asc-842-private-company-elections-and-lease-modifications; the general framework is in /us/blog/asc-842-lease-accounting.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- PwC Viewpoint, Leases guide, 4.3 Initial recognition and measurement, lessor: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/leases/leases__4_US/chapter_4_accounting_US/43_initial_recogniti_US.html
- PwC Viewpoint, Leases guide, 3.3 Lease classification: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/leases/leases__4_US/chapter_3_lease_clas_US/33_lease_classificat_US.html
- PwC Viewpoint, Leases guide, 3.6 Lessor classification examples: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/leases/leases__4_US/chapter_3_lease_clas_US/36_lessor_classifica_US.html
- PwC Viewpoint, Leases guide, 4.7 Impairment, lessor: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/leases/leases__4_US/chapter_4_accounting_US/47_impairment_lessor_US.html
- Deloitte DART, Roadmap: Leases, 9.2 Lease classification (lessor): https://dart.deloitte.com/USDART/home/codification/broad-transactions/asc842-10/roadmap-leasing/chapter-9-lessor-accounting/9-2-lease-classification
- Deloitte DART, Roadmap: Leases, 9.3 Recognition and measurement (lessor): https://dart.deloitte.com/USDART/home/codification/broad-transactions/asc842-10/roadmap-leasing/chapter-9-lessor-accounting/9-3-recognition-measurement
- Sikich, Dear lessors, we're sorry if we made you feel lesser: https://www.sikich.com/insight/dear-lessors-were-sorry-if-we-made-you-feel-lesser/
Part of CORAA University · US GAAP for private companies: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error