A lessor is the party in a lease that owns an asset and grants another party the right to use it for a set period in return for payments. The other party is the lessee. Lessors include landlords who rent out buildings, equipment leasing companies, car manufacturers' finance arms, aircraft lessors and banks that offer asset finance. The terms between the two parties are set out in a lease agreement.
Lessor accounting answers a basic question: has the lessor, in substance, sold the asset and become a lender, or has it kept the asset and simply rented it out? The answer decides whether the asset stays on the lessor's balance sheet and whether its income is reported as rental revenue or as interest. In the United States the rules are in ASC 842, issued by the Financial Accounting Standards Board (FASB); internationally they are in IFRS 16, issued by the International Accounting Standards Board (IASB).
How lessors classify leases
Although both standards changed lessee accounting sharply, they left the lessor model largely as it was. A lessor classifies each lease at the start:
- Sales-type lease (US GAAP) or finance lease (IFRS): the lease transfers substantially all the risks and rewards of ownership, for example because ownership passes to the lessee, the lease covers the major part of the asset's economic life, or the present value of payments equals substantially all of its fair value. The lessor removes the asset and records a net investment in the lease, which is a receivable.
- Direct financing lease (US GAAP only): a lease that does not meet the sales-type tests by itself but does once a third-party residual value guarantee is included. It is accounted for much like a sales-type lease, except that any selling profit is deferred.
- Operating lease: any other lease. The lessor keeps the asset on its books, records depreciation, and recognizes lease income, usually on a straight-line basis.
Worked example of an operating lease
A property company owns an office floor that cost $2,400,000, which it depreciates over 40 years. It leases the floor for five years at $180,000 a year, with the first year rent-free as an incentive, so total payments are $720,000. Under straight-line recognition, the lessor reports rent income of $720,000 divided by 5, or $144,000 a year. In year one it receives no cash, so it debits a deferred rent receivable $144,000 and credits lease income $144,000. It also records annual depreciation of $60,000 on the building. In later years, cash of $180,000 exceeds income of $144,000 and the receivable unwinds.
Worked example of a sales-type lease
An equipment maker leases a machine with a fair value of $100,000 and a cost of $70,000 for its full five-year life, at an implicit rate of 6 percent, with annual payments in arrears of about $23,740. At the start, the lessor removes the machine from inventory, records a net investment in the lease of $100,000, recognizes revenue of $100,000 and cost of sales of $70,000, giving a selling profit of $30,000. Over the lease it earns interest income at 6 percent on the outstanding receivable: $6,000 in year one, falling each year as payments reduce the balance. This income is reported as interest revenue.
Lessors face credit risk on the lessee, and residual value risk, which is the chance that the asset is worth less than expected when it comes back at the end of the lease. Operating lessors also bear the cost of maintenance, insurance and obsolescence unless the contract passes them to the tenant. Under both frameworks, lessors must disclose a maturity analysis of lease payments to be received, and IFRS lessors must assess net investments in finance leases for expected credit losses. Large property lessors are often organized as a real estate investment trust (REIT), whose revenue comes almost entirely from operating lease income on real estate. A lessor's operating lease assets remain among its fixed assets and are tested for impairment in the usual way.