The FASB on July 19, 2021, issued an accounting rule that requires certain sales and direct financing leases with payments that vary to be recorded as operating leases, a change that enables companies to avoid booking a loss on profitable contracts.
The change amends Topic 842, Leases, to require lessors to classify and account for a lease with variable payments as an operating lease if “the lease would have been classified as a sales-type lease or a direct financing lease” and the lessor “would have otherwise recognized a day-one loss.”
The resulting financial reporting will more faithfully represent the economics underlying the lease and improve the usefulness of information provided to investors and other financial statement users, the board said.
The amendments are effective for fiscal years beginning after December 15, 2021, for all entities, and interim periods within those fiscal years for public companies and interim periods within fiscal years beginning after December 15, 2022, for private companies and other entities.
Appearance of a Loss on Day One
Topic 842 requires that a lessor determine whether a lease should be classified as a sales-type lease or a direct financing lease at the start of a lease on the basis of specified classification criteria. The rules do not permit a lessor to estimate most variable payments and must exclude variable payments that are not estimated and do not depend on a reference index or a rate from the lease receivable.
Some lessors found that leases with a variable payment structure included into them could cause the appearance of a loss on the very first day of the lease due to how payments and timing of those payments are structured, even though the the lease would prove to be profitable in the long run.
“This amendment is going to correct for that,” Sarah O’Sullivan, accounting director at LeaseQuery said on July 19. “And so if a lessor is entering a lease and it would qualify as a sales-type or a direct financing lease and it has a variable payment structure, then they would be required to default to accounting for it as an operating lease and when you have an operating lease you do not have an income statement impact so that will get rid of this possibility of having to take a loss at the very beginning of the lease,” she said.
Electricity Providers First Requested the Changes
The topic was initially flagged last year by the Edison Electric Institute (EEI), which represents providers like Consolidated Energy (Con Ed) and PG&E Corp., among others.
EEI in a letter told the FASB that the issue was pervasive for the electric energy industry, in particular arrangements for the purchase and sale of energy from renewable (solar and wind) power generation facilities that are in many cases paired with a battery storage system.
At issue for that sector is that Topic 842 does not allow companies to include variable payments when computing the investment in the lease. As a result little to no net investment in the lease is eligible to be recorded at the start of the lease, causing a loss for most if not all of the carrying amount of the identified asset when it is derecognized by the lessor.
Two Board Members Dissent
As expected, FASB members Christine Botosan and Harold Schroeder (who left the board on June 30 due to term limits) wrote dissents on the ASU over concerns “about the amendments and the assessment of whether to reexpose before its issuance.”
Among other remarks, Botosan and Schroeder said “excluding certain variable lease payments from the measurement of a lease at inception can give rise to selling losses and profits that do not reflect the economics of the contract reported by lessors whose contracts include a significant portion of variable payments, which is the direct consequence of a prior Board’s decision.”
They also would have “preferred to reconsider that prior decision holistically for lessees and lessors as part of the ongoing post-implementation review of Topic 842.”
For in-depth analysis of the FASB’s standard for lease accounting, please see Catalyst: US GAAP — Leases , also on Checkpoint.
Additional analysis of the lease standard can be found in the Accounting and Auditing Update Service[AAUS] No. 2016-15 and SEC Accounting and Reporting Update Service[SARU] No. 2016-13 (March 2016): Special Report: Accounting for Leases—an Explanation and Analysis of Accounting Standards Update No. 2016-02.
This article originally appeared in the July 20, 2021 edition of Accounting & Compliance Alert, available on Checkpoint.
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