Before the release of the ASU, sales-type leases or direct financing leases with significant variable payments may have resulted in a day 1 loss on the arrangement even if the overall economics of the arrangement were expected to be profitable. This is because, under ASC 842, Leases, variable payments are excluded from the definition of lease payments for both lessees and lessors. Accordingly, lessors exclude variable payments when measuring the net investment in the lease. As a result, the recognition of the net investment in the lease may be lower than the derecognition of the underlying asset.

The FASB issued ASU 2021-05 to address this uneconomic outcome. This amendment only affects lessor accounting and will have no impact on lessees.

Note that the ASU does not prescribe a threshold for the amount of variable payments; for an entity to apply the ASU’s guidance, a lease only needs to contain some amount of variable payments.

As a result of ASU 2021-05, we expect more lessors to classify leases as operating leases as opposed to sales-type leases or direct financing leases. Accordingly, additional leases will qualify for the lessor practical expedient pursuant to ASC 842-10-15-42A which allows lessors to combine lease and nonlease components into a single component if certain scope requirements are met. One such requirement is that the underlying lease component must be classified as an operating lease. Therefore, as a result of the ASU, additional leases will qualify for the lessor practical expedient.

Effective Date and Transition

Lessors that have adopted ASC 842 as of 19 July 2021, should apply the amendments contained in ASU 2021-05 to the fiscal years beginning after 15 December 2021. Early adoption of ASU 2021-05 is permitted, as long as the adoption of this ASU does not occur before the adoption of ASC 842.

You can find more information about ASU 2021-05 in Heads Up | Volume 28, Issue 8.