New Lease Standard – Part 1: Types of Leases

By November 1st, 2022 November 17th, 2022 Audit

The effective date of the new lease standard (ASC 842) is approaching. For calendar year private companies, it is effective at the end of 2022, but it should be applied at the beginning of the fiscal year when you prepare financial statements at the end of the fiscal year. We will be covering the leasing issues for the next several articles.

Summary

First, the lease is described as a contract that conveys the right to control the use of an identified asset, using the control concept familiar from the new revenue recognition standard. Until now, it has been described as “An agreement conveying the right to use property, plant, or equipment.”

The new lease standard makes the following distinctions

Lessor side   Lessee side
Sales -type Finance
Direct financing Operating
Operating Operating

The old standard was as follows:

Lessor side   Lessee side
Sales -type (Capital) Capital
Direct financing (Capital) Capital
Operating Operating

The term “capital lease” has been eliminated, but it can be roughly understood that the capital lease has been replaced by a sales-type lease.

Sales-type lease terms and conditions

Underlying is the following control concept from the new revenue recognition standard.

“Control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from the asset.”

In order to account for a lease as if the asset were sold, it needs to not only “convey the right to control the use” as described above, but also requires that “substantially all of the remaining benefits from the asset” be transferred to the lessee. The conditions for determining whether or not there has been a transfer of control and treating it as a sales-type lease are as follows.

One of the following conditions (simplified) must be met

  1. The lease transfers ownership of the underlying asset to the lessee on or before the end of the lease term.
  2. The lease gives the lessee an option to purchase the asset and the lessee is reasonably certain to exercise that option.
  3. The lease term represents the major part of the remaining economic life of the underlying asset.
  4. The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset.
  5. The underlying asset is so specialized for a particular purpose that it is not expected to have an alternative use to the lessor when the lease is over.

    3 and 4. are not much different from the so called 75% and 90% standards for conventional capital leases. Item 5. is a new addition.

Operating lease

If none of the above conditions are met, the lease is an operating lease for lessee. On the other hand, for a lessor, if both of the following conditions are met, it is a direct financing lease, and if not, it is an operating lease.

  1. The present value of the sum of the lease payments and any residual value guaranteed by the lessee and/or any other third party unrelated to the lessor.
  2. It is probable the lessor will collect the lease payments plus any applicable residual value guarantee.

Meaning of Direct financing lease

Condition a. of this direct financing lease is confusingly similar to condition 4. of a sales-type lease, but the meaning is as follows.

Sales-type lease condition 4.

Present value of lease payments+ Residual value guaranteed by the lessee≧ the fair value of the underlying asset

Terms and Conditions of Direct Financing Leases a.

Present value of lease payments+ Residual value guaranteed by the lessee+ Residual value guaranteed by third-party≧the fair value of the underlying asset.

or

Present value of lease payments+ Residual value guaranteed by third-party≧the fair value of the underlying asset

In other words, the above inequality (≧) is true only when there is a third-party guarantee.

Under the previous standard, direct financing leases were described as follows:

Fulfillment of one of the four conditions of a capital lease (transfer of ownership, bargain purchase option, 75% of useful life, 90% of fair value); no benefit to the lessor as a manufacturer or dealer. Under the old standard, a third-party guarantee was also included in the minimum lease payment when determining the 90%.

In other words, a direct financing lease under the old standard focuses on whether there is a profit on sales, and under the new standard, it can be either a sales-type lease or a direct financing lease.

This is the result of linking the sales-type lease in the new lease standard to the transfer of control in the new revenue recognition standard. The direct financing lease in the new lease standard does not satisfy the conditions of a sales-type lease and does not transfer control, but it is considered that the risk of holding the leased asset is effectively replaced by the credit risk, and thus this classification is established.