FASB addressed operating lease impairment accounting at its July 17, 2019, public meeting. Unlike the revenue recognition and credit impairment standards, FASB did not form a transition resource task group for the new lease guidance, Accounting Standards Codification (ASC) 842. Several subsequent amendments have been issued to address issues and concerns raised; however, some inquiries do not merit standard setting but may be pervasive enough to warrant further clarification to a broader audience. Accounting Standards Update 2018-19 clarified that operating lease receivables are not covered by the CECL credit impairment model, but rather should be accounted for under ASC 842, which raised additional questions.
ASC 842 introduces a collectibility constraint whereby operating lease revenue is recognized on a systematic basis only when collectibility of the lease payments is probable. A lessor must assess the collectibility of lease payments for all operating leases on an individual basis at lease commencement. If collectibility for a particular lease payment is not probable at that date, the lessor would recognize lease revenue when payments are received (cash basis), and no receivable is established until it becomes probable that the lease payments will be collected.
Previously, entities applied guidance in ASC 310, Receivables, which references ASC 450, Contingencies, whereby they recognized reserves for the portion of an operating lease portfolio that—based on historical data—is not expected to be collected.
A strict interpretation of ASC 842’s new requirement would mean that no general allowance for an operating lease portfolio could be recognized; however, ASC 842 does not specifically prohibit a general reserve. FASB acknowledged it did not intend to significantly change existing practice for accounting for the impairment of lease operating receivables and offered two broad accounting methods that would reduce disruptions to current practice. Lessors should disclose how they are accounting for the impairments of operating leases.
Method 1: Impairment Recognized Only at the Individual Lease Level
Under this method, a lessor would apply a strict interpretation of ASC 842 and account for the impairment of operating leases solely at the individual lease level. At lease commencement and subsequently, a lessor would analyze each operating lease on an individual basis to determine whether collectibility of the lease payments is probable. If collectibility is not probable, a lessor would recognize revenue on a cash basis—any revenue previously accrued and reflected in a receivable balance would be reversed against lease revenue in the period the lease payment is not considered collectible. If collectibility of the lease payments is subsequently determined to be probable, the lessor would recognize any revenue that would have been accrued on a straight-line basis and in excess of cash revenue already recognized as a current-period adjustment to lease revenue. Under this method, no general allowance would be recognized on an operating lease portfolio. In addition, revenue recognized collectively will equal cash received.
Method 2: A General Allowance in Accordance with Topic 450 Is Recognized in Conjunction with the Guidance in ASC 842
Under this method, a lessor initially would analyze each of its operating leases at the individual level to determine whether it is probable that the lease payments are collectible. If collectibility for an individual lease is not considered probable, the lessor recognizes lease revenue for that individual lease on a cash basis, consistent with Method 1. For a portfolio of operating leases that are individually considered collectible but for which the lessor estimates that a portion ultimately will be uncollectible, a general allowance may be established and maintained in accordance with ASC 450, assuming the lessor complies with the ASC 450 recognition and measurement requirements. FASB expects the general allowance accounting under this method will be consistent with today’s practice under ASC 450. FASB believes it is acceptable for the general reserve accounting for operating lease receivables to be consistent with that currently applied for trade receivables (before CECL becomes effective), as long as a lessor ceases recognizing lease revenue on a straight-line basis for an individual lease when collectibility is no longer probable for that lease.
The adoption of ASC 842 will be complex and likely will require significant hours to implement correctly. BKD can help educate your team, provide implementation tools and assist with analysis and documentation. If you would like assistance complying with the lease standard, contact your BKD trusted advisor. BKD has prepared a library of BKD Thoughtware® on this topic. Visit our website to learn more.