An explanation of the issues discussed in the document,? The FASB position on the issue including the FASB arguments supporting

Leases (Topic 842)

No. 2021-05 July 2021

Lessors—Certain Leases with Variable Lease Payments

An Amendment of the FASB Accounting Standards Codification®

The FASB Accounting Standards Codification® is the source of authoritative generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. An Accounting Standards Update is not authoritative; rather, it is a document that communicates how the Accounting Standards Codification is being amended. It also provides other information to help a user of GAAP understand how and why GAAP is changing and when the changes will be effective. For additional copies of this Accounting Standards Update and information on applicable prices and discount rates contact: Order Department Financial Accounting Standards Board 401 Merritt 7 PO Box 5116 Norwalk, CT 06856-5116 Please ask for our Product Code No. ASU 2021-05. FINANCIAL ACCOUNTING SERIES (ISSN 0885-9051) is published monthly with the exception of January, March, July, and October by the Financial Accounting Foundation, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116. Periodicals postage paid at Norwalk, CT and at additional mailing offices. The full subscription rate is $328 per year. POSTMASTER: Send address changes to Financial Accounting Series, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856- 5116. | No. 507

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An Amendment of the FASB Accounting Standards Codification®

No. 2021-05 July 2021

Leases (Topic 842)

Lessors—Certain Leases with Variable Lease Payments

Accounting Standards Update

Financial Accounting Standards Board

Accounting Standards Update 2021-05

Leases (Topic 842)

Lessors—Certain Leases with Variable Lease Payments

July 2021

CONTENTS

Page Numbers

Summary …………………………………………………………………………………………….. 1–3 Amendments to the FASB Accounting Standards Codification® ………………… 5–16 Background Information and Basis for Conclusions ……………………………….. 17–25 Amendments to the GAAP Taxonomy ……………………………………………………….. 26

1

Summary

Why Is the FASB Issuing This Accounting Standards Update (Update)?

On February 25, 2016, the FASB issued Accounting Standards Update No. 2016- 02, Leases (Topic 842), to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing transactions.

As part of the Board’s post-implementation review (PIR) of Topic 842, the Board and staff continue to assist stakeholders by responding to inquiries received and proactively seeking feedback on potential implementation issues that have arisen as public business entities began implementing Topic 842. Since the issuance of Update 2016-02, the Board has issued five Updates to assist stakeholders with implementation issues and two Updates deferring the effective date for private companies and certain not-for-profit organizations. Additionally, the FASB staff has responded to approximately 300 technical inquiries during that time. Finally, the Board has provided a dedicated section on its website for PIR.

Also as part of the Board’s PIR of Topic 842, the Board and staff continue to perform outreach with various stakeholder organizations to address any additional issues that may have arisen since the adoption of Topic 842 by public business entities. The amendments in this Update address an issue related to a lessor’s accounting for certain leases with variable lease payments.

Who Is Affected by the Amendments in This Update?

The amendments in this Update affect lessors with lease contracts that (1) have variable lease payments that do not depend on a reference index or a rate and (2) would have resulted in the recognition of a selling loss at lease commencement if classified as sales-type or direct financing.

How Do the Main Provisions Differ from Current Generally Accepted Accounting Principles (GAAP) and Why Are They an Improvement?

Topic 842 requires that a lessor determine whether a lease should be classified as a sales-type lease or a direct financing lease at lease commencement on the basis of specified classification criteria (see paragraphs 842-10-25-2 through 25-3). Under Topic 842, a lessor is not permitted to estimate most variable payments and must exclude variable payments that are not estimated and do not depend on a

2

reference index or a rate from the lease receivable. Subsequently, those excluded variable payments are recognized entirely as lease income when the changes in facts and circumstances on which those variable payments are based occur. Consequently, the net investment in the lease for a sales-type lease or a direct financing lease with variable payments of a certain magnitude that do not depend on a reference index or a rate may be less than the carrying amount of the underlying asset derecognized at lease commencement. As a result, the lessor recognizes a selling loss at lease commencement (hereinafter referred to as a day- one loss) even if the lessor expects the arrangement to be profitable overall.

Certain preparers and practitioners have continued to highlight that recognizing a day-one loss for a sales-type lease with variable payments that do not depend on a reference index or a rate results in reporting outcomes that do not faithfully represent the underlying economics either at lease commencement or over the lease term. Those stakeholders emphasized that users of financial statements are not provided with financial information that is relevant or decision useful in those cases. Rather, the reporting of a loss is counter to the economics of those arrangements, and, thus, the accounting previously required fails to represent the underlying economics neutrally and faithfully. Lease arrangements with variable payment structures based on the performance or use of underlying assets are becoming more prevalent, particularly in the energy industry, and stakeholders from that industry requested that the Board amend the leases guidance to address this issue. This issue also may exist for a direct financing lease with variable payments that do not depend on a reference index or a rate.

Those stakeholders further highlighted that lessors did not recognize a day-one loss under Topic 840, Leases, because of the longstanding practice to account for certain leases with variable payments as operating leases based on an interpretation of a classification criterion in Topic 840. That classification criterion was not retained in Topic 842. Additionally, the resulting day-one loss issue was not identified or discussed by the Board in deliberations leading to the issuance of Update 2016-02.

The amendments in this Update address stakeholders’ concerns by amending the lease classification requirements for lessors to align them with practice under Topic 840. Lessors should classify and account for a lease with variable lease payments that do not depend on a reference index or a rate as an operating lease if both of the following criteria are met:

1. The lease would have been classified as a sales-type lease or a direct financing lease in accordance with the classification criteria in paragraphs 842-10-25-2 through 25-3.

2. The lessor would have otherwise recognized a day-one loss.

When a lease is classified as operating, the lessor does not recognize a net investment in the lease, does not derecognize the underlying asset, and, therefore, does not recognize a selling profit or loss. The leased asset continues to be subject to the measurement and impairment requirements under other applicable GAAP

3

before and after the lease transaction (for example, Topic 360, Property, Plant, and Equipment).

When Will the Amendments Be Effective and What Are the Transition Requirements?

The amendments in this Update amend Topic 842, which has different effective dates for public business entities and most entities other than public business entities. The amendments are effective for fiscal years beginning after December 15, 2021, for all entities, and interim periods within those fiscal years for public business entities and interim periods within fiscal years beginning after December 15, 2022, for all other entities.

Entities that have not adopted Topic 842 on or before the issuance date of this Update should follow the transition requirements of Topic 842 in paragraph 842- 10-65-1 for the amendments in this Update. This transition is either (1) retrospective to each prior period presented in the financial statements with the cumulative effect of transition recognized at the beginning of the earliest period presented or (2) retrospective to the beginning of the period of adoption with a cumulative effect of transition recognized at the beginning of the period of adoption.

Entities that have adopted Topic 842 before the issuance date of this Update have the option to apply the amendments in this Update either (1) retrospectively to leases that commenced or were modified on or after the adoption of Update 2016- 02 or (2) prospectively to leases that commence or are modified on or after the date that an entity first applies the amendments.

Earlier application is permitted.

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Amendments to the FASB Accounting Standards Codification®

Introduction

1. The Accounting Standards Codification is amended as described in paragraphs 2–20. In some cases, to put the change in context, not only are the amended paragraphs shown but also the preceding and following paragraphs. Terms from the Master Glossary are in bold type. Added text is underlined, and deleted text is struck out.

Amendments to Master Glossary

2. Amend the following Master Glossary terms, with a link to transition paragraph 842-10-65-5, as follows:

Direct Financing Lease

From the perspective of a lessor, a lease that meets none of the criteria in paragraph 842-10-25-2 but meets the criteria in paragraph 842-10-25-3(b) and is not an operating lease in accordance with paragraph 842-10-25-3A.

Sales-Type Lease

From the perspective of a lessor, a lease that meets one or more of the criteria in paragraph 842-10-25-2 and is not an operating lease in accordance with paragraph 842-10-25-3A.

Amendments to Subtopic 842-10

3. Amend paragraph 842-10-15-42A and add paragraph 842-10-25-3A, with a link to transition paragraph 842-10-65-5, as follows:

Leases—Overall

Scope and Scope Exceptions

> Separating Components of a Contract

> > Lessor

6

842-10-15-42A As a practical expedient, a lessor may, as an accounting policy election, by class of underlying asset, choose to not separate nonlease components from lease components and, instead, to account for each separate lease component and the nonlease components associated with that lease component as a single component if the nonlease components otherwise would be accounted for under Topic 606 on revenue from contracts with customers and both of the following are met:

a. The timing and pattern of transfer for the lease component and nonlease components associated with that lease component are the same.

b. The lease component, if accounted for separately, would be classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3A 25-3.

Recognition

> Lease Classification

842-10-25-2 A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

c. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.

e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

842-10-25-3 When none of the criteria in paragraph 842-10-25-2 are met:

a. A lessee shall classify the lease as an operating lease. b. A lessor shall classify the lease as either a direct financing lease or an

operating lease. A lessor shall classify the lease as an operating lease unless both of the following criteria are met, in which case the lessor shall classify the lease as a direct financing lease:

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1. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.

2. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

842-10-25-3A Notwithstanding the requirements in paragraphs 842-10-25-2 through 25-3, a lessor shall classify a lease with variable lease payments that do not depend on an index or a rate as an operating lease at lease commencement if classifying the lease as a sales-type lease or a direct financing lease would result in the recognition of a selling loss.

4. Add paragraph 842-10-65-5 and its related heading as follows:

Transition and Open Effective Date Information

> Transition Related to Accounting Standards Update No. 2021-05, Leases (Topic 842): Lessors—Certain Leases with Variable Lease Payments

842-10-65-5 The following represents the transition and effective date information related to Accounting Standards Update No. 2021-05, Leases (Topic 842): Lessors—Certain Leases with Variable Lease Payments:

a. An entity that has not yet adopted the pending content that links to paragraph 842-10-65-1 as of July 19, 2021, shall apply the pending content that links to this paragraph when it first applies the pending content that links to paragraph 842-10-65-1 and shall apply the same transition method elected for the pending content that links to paragraph 842-10-65-1.

b. An entity within the scope of paragraph 842-10-65-1(a) that has adopted the pending content that links to paragraph 842-10-65-1 as of July 19, 2021, shall apply the pending content that links to this paragraph for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. Earlier application is permitted.

c. An entity within the scope of paragraph 842-10-65-1(b) that has adopted the pending content that links to paragraph 842-10-65-1 as of July 19, 2021, shall apply the pending content that links to this paragraph for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Earlier application is permitted.

d. An entity within the scope of (b) or (c) shall apply the pending content that links to this paragraph by using one of the following two methods:

8

1. Retrospectively to the date in which the pending content that links to paragraph 842-10-65-1 was adopted (the beginning of the period of adoption of Topic 842). Under this transition method, the entity shall apply the pending content that links to this paragraph to leases that commence or are modified on or after the beginning of the period of its adoption of Topic 842 and do not meet the conditions in paragraph 842-10-25-8.

2. Prospectively to leases that commence or are modified on or after the date that the entity first applies the pending content that links to this paragraph and do not meet the conditions in paragraphs 842-10- 25-8.

e. An entity within the scope of (b) or (c) that elects the transition method in (d)(1) shall provide the following transition disclosures: 1. The applicable transition disclosures required by Topic 250 on

accounting changes and error corrections, except for the requirements in paragraph 250-10-50-1(b)(2) and paragraph 250-10- 50-3

2. The transition disclosures in paragraph 250-10-50-1(b)(3) as of the beginning of the earliest period presented but not before the date in which the pending content that links to paragraph 842-10-65-1 was adopted.

f. An entity within the scope of (b) or (c) that elects the transition method in (d)(2) shall provide the following transition disclosures: 1. The nature of and reason for the change in accounting principle 2. The transition method 3. A qualitative description of the financial statement line items affected

by the change.

Amendments to Status Sections

5. Amend paragraph 255-10-00-1, by adding the following items to the table, as follows: 255-10-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

9

6. Amend paragraph 310-10-00-1, by adding the following items to the table, as follows: 310-10-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

7. Amend paragraph 450-30-00-1, by adding the following items to the table, as follows: 450-30-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

8. Amend paragraph 805-10-00-1, by adding the following items to the table, as follows: 805-10-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

9. Amend paragraph 805-20-00-1, by adding the following items to the table, as follows:

10

805-20-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

10. Amend paragraph 810-10-00-1, by adding the following items to the table, as follows: 810-10-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

11. Amend paragraph 840-10-00-1, by adding the following items to the table, as follows: 840-10-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

12. Amend paragraph 840-20-00-1, by adding the following items to the table, as follows: 840-20-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

11

13. Amend paragraph 840-30-00-1, by adding the following items to the table, as follows: 840-30-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

14. Amend paragraph 840-40-00-1, by adding the following items to the table, as follows: 840-40-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

15. Amend paragraph 842-10-00-1, by adding the following items to the table, as follows: 842-10-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021 842-10-15-42A Amended 2021-05 07/19/2021 842-10-25-3A Added 2021-05 07/19/2021 842-10-65-5 Added 2021-05 07/19/2021

16. Amend paragraph 842-20-00-1, by adding the following items to the table, as follows:

12

842-20-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

17. Amend paragraph 842-30-00-1, by adding the following items to the table, as follows: 842-30-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

18. Amend paragraph 842-40-00-1, by adding the following items to the table, as follows: 842-40-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

19. Amend paragraph 860-10-00-1, by adding the following items to the table, as follows: 860-10-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

13

20. Amend paragraph 970-340-00-1, by adding the following items to the table, as follows: 970-340-00-1 The following table identifies the changes made to this Subtopic.

Paragraph Action

Accounting

Standards

Update Date

Direct Financing

Lease Amended 2021-05 07/19/2021 Sales-Type Lease Amended 2021-05 07/19/2021

The amendments in this Update were adopted by the affirmative vote of five members of the Financial Accounting Standards Board. Ms. Botosan and Mr. Schroeder dissented.

Ms. Botosan and Mr. Schroeder dissent from the issuance of this Update because of concerns about the amendments and the assessment of whether to reexpose before its issuance.

Concerns about Amendments

Ms. Botosan and Mr. Schroeder acknowledge that 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 would have preferred to reconsider that prior decision holistically for lessees and lessors as part of the ongoing post-implementation review of Topic 842.

Barring a holistic reassessment, Ms. Botosan and Mr. Schroeder would have supported an alternative approach aligned with the one exposed. That proposed approach would have required that lessors classify and account for a sales-type lease with predominantly variable lease payments as an operating lease. They believe that such an approach would have addressed the immediate problem of reporting nonrepresentationally faithful selling losses and profits by lessors whose contracts include a significant portion of variable payments. Furthermore, that approach was supported by most respondents to the proposed Accounting Standards Update, Leases (Topic 842): Targeted Improvements. During redeliberations, however, a Board majority directed the staff to evaluate an alternative approach recommended by a small number of respondents to the proposed Update. That alternative approach, which was ultimately supported by the Board majority, requires that a lessor classify and account for a sales-type (or direct financing) lease with a selling loss at inception as an operating lease if there

14

is any amount (referred to in this dissent as a nonzero amount) of variable lease payments.

The revised approach alters the scope of this Update relative to the proposed amendments by extending the scope to direct financing and sales-type leases with a day-one loss, regardless of the magnitude of variable lease payments. In addition, it excludes sales-type leases with selling profits that do not faithfully represent the economic profit resulting from those contracts because of variable payments. Thus, this approach has little to do with the root cause of the accounting misalignment—excluded variable lease payments—but, instead, focuses on day- one losses regardless of their cause.

Also, Ms. Botosan and Mr. Schroeder, citing the basis for conclusions in the proposed Update, observe that “having a threshold that is too low could promote structuring to achieve operating lease accounting.” They believe that reducing the threshold from predominant to a nonzero amount of variable lease payments will invite precisely the type of structuring about which the Board previously expressed concern. Under the amendments in this Update, an entity will be able to choose whether to account for a lease as a sales-type lease (direct financing lease) or an operating lease by structuring the transaction to achieve the desired outcome. The amendments create a rules-based, nonneutral bright line such that any amount of selling loss combined with a nonzero amount of variable lease payments achieves operating lease accounting, whereas any amount of selling profit achieves sales- type (direct financing) lease accounting.

Concerns about Assessment of Whether to Reexpose

Ms. Botosan and Mr. Schroeder disagree with the majority’s evaluation of the factors that the Board considered in evaluating the need for a revised Exposure Draft. Those factors include (1) Is one or more changes during redeliberations significant? and (2) Has the changed guidance previously been exposed for public comment? Their reasoning is outlined in the following paragraphs.

Is One or More Changes during Redeliberations Significant?

The Board’s internal policies, procedures, and guidance (Supplemental PP&G) indicate that financial reporting results that “differ significantly from that which would have been reported under the Exposure Draft” represents a significant change. Ms. Botosan and Mr. Schroeder believe that altering the proposed scope to focus on the existence of a selling loss and reducing the threshold for variable payments from predominant to any nonzero amount will yield financial reporting results that differ significantly from those that would have been reported under the proposed amendments. Therefore, they believe that the revised scope and revised solution both should have been reexposed for public comment.

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Has the Changed Guidance Previously Been Exposed for Public Comment?

The Supplemental PP&G indicates that a significant change has been exposed for public comment when the revised amendments revert to existing GAAP or are “responsive to suggestions made and supported by a significant number of respondents and are not opposed by any significant stakeholder group.” Regarding existing GAAP (which is now Topic 842), Ms. Botosan and Mr. Schroeder note that the revised amendments clearly do not revert to existing GAAP, and they believe that the revised amendments do not revert to prior GAAP under the superseded Topic 840. In support of their belief, they note that in outreach all practitioners agreed that Topic 840 did not directly address lessors’ classification of leases with a certain magnitude of variable payments. Rather, lessors’ classification of those leases as operating was based on a practice interpretation of a lessor-classification criterion. They note that the paragraph 840-10-25-42(b) criterion did not refer to the existence of a selling loss, but to “no important uncertainties” surrounding the amount of nonreimbursable costs yet to be incurred by the lessor.

Those practitioners acknowledged that the interpretation was applied inconsistently in practice. For example, one firm observed that lessors with either a day-one gain or a day-one loss would classify and account for a lease as an operating lease under Topic 840 if the lease in

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