Lessor accounting: sales-type, direct financing and operating leases

• Classify a lessor lease as sales-type, direct financing or operating
• Measure the net investment in a sales-type lease and compute selling profit
• Apply the collectibility rules for sales-type and operating leases
• Account for lessor modifications and identify which lessor balances fall under CECL

Classification for lessors

A lessor uses the same five criteria in 842-10-25-2 as a lessee. If any is met, the lease is a sales-type lease. When none is met, the lessor classifies the lease as direct financing only if both (842-10-25-3):

1. the present value of the lease payments plus any residual value guaranteed by the lessee or any unrelated third party equals or exceeds substantially all of the fair value of the asset, and
2. it is probable the lessor will collect the lease payments plus any amount needed to satisfy a residual value guarantee.

Otherwise the lease is operating. The lessor assesses the present value tests using the rate implicit in the lease (842-10-25-4). Direct financing arises when a lease falls short of the sales-type criteria only because the lessee does not guarantee enough of the residual, and a third party, such as a residual value insurer, does.

One override comes from ASU 2021-05. A lease with variable payments that do not depend on an index or rate is classified as operating at commencement if sales-type or direct financing classification would produce a selling loss (842-10-25-3A). Without it, a lessor would book a day-one loss because those variable payments stay out of the net investment.

Sales-type leases

At commencement the lessor derecognizes the underlying asset and recognizes a net investment in the lease and any selling profit or loss (842-30-25-1). The net investment is the lease receivable plus the present value of the unguaranteed residual, both discounted at the rate implicit (842-30-30-1). Initial direct costs are expensed if fair value differs from carrying amount; otherwise they are deferred inside the net investment.

After commencement the lessor recognizes interest income on the net investment, variable payments not in the net investment when earned, and impairment of the net investment (842-30-25-2). That impairment runs through Topic 326: a net investment in a sales-type or direct financing lease is in the scope of the CECL model in 326-20.

Collectibility matters at commencement. If collection of the lease payments plus any lessee residual value guarantee is not probable, the lessor keeps the asset on its books and records payments received as a deposit liability until collectibility becomes probable or the contract ends with nonrefundable payments (842-30-25-3). If collectibility was probable at commencement, the lessor does not reassess it later; changes in credit risk flow through the allowance (842-30-25-6).

Direct financing leases

The lessor derecognizes the asset and records a net investment, but selling profit and initial direct costs are deferred into the net investment (842-30-25-7 and 25-8). A selling loss is recognized immediately. Profit comes through interest income over the term.

Operating leases

The lessor keeps the asset on its balance sheet and keeps depreciating it (842-30-35-6). It recognizes lease payments as income on a straight-line basis over the term unless another systematic and rational basis better reflects the benefit pattern, variable payments when earned, and deferred initial direct costs as expense on the same basis (842-30-25-10 and 25-11). If collectibility is not probable at commencement, income is limited to the lesser of straight-line income or payments collected (842-30-25-12). A later change in that assessment is a current-period catch-up adjustment (842-30-25-13).

Operating lease receivables are excluded from 326-20 (326-20-15-3, as amended by ASU 2018-19); the collectibility guidance in Topic 842 applies instead. Clients that book a general reserve against straight-line rent receivables under CECL are applying the wrong model.

Lessor modifications

A modification that meets both 842-10-25-8 conditions is a separate contract, as for a lessee. Otherwise the lessor follows 842-10-25-15 through 25-17:

• Operating lease modified. Treat it as a termination of the old lease and a new lease starting at the modification date. If the new lease is operating, prepaid or accrued rent from the old lease becomes part of the new lease payments.
• Direct financing lease modified, still direct financing. Adjust the discount rate so the initial net investment in the modified lease equals the carrying amount of the old net investment. No gain or loss.
• Direct financing or sales-type lease modified into an operating lease. The underlying asset goes back on the books at the carrying amount of the old net investment.
• Direct financing lease modified into a sales-type lease. Apply sales-type accounting from the modification date, with selling profit or loss measured against the old net investment.

Audit points

• Recompute the rate implicit from fair value, payments and residual estimate.
• Test the residual value assumption against appraisals or used asset prices.
• Agree straight-line rent schedules to leases, including free rent periods.
• For real estate lessors, the straight-line rent guide covers tenant-level collectibility.

Sales-type lease of a compressor by Summit Air Systems, Inc.