CECL Considerations for Direct Financing Leases

CECL Considerations for Direct Financing Leases

One common question from lessors is how to apply the Current Expected Credit Loss (CECL) model under ASC 326 to direct financing leases. Specifically, how should the net investment in the lease be evaluated for credit losses when it includes both financial and non-financial components?

Under ASC 326-20, lessors must measure expected credit losses on the entire net investment in the lease. This includes the lease receivable (the present value of lease payments and any guaranteed residual value) and the unguaranteed residual asset. While the unguaranteed residual does not meet the definition of a financial asset, it is still included in the scope of CECL for direct financing leases.

At the June 2018 meeting of the FASB’s Transition Resource Group (TRG), the staff clarified that entities must estimate expected cash flows from the eventual disposition of leased assets. These estimates should reflect both potential gains and losses upon disposal. This means that even though the unguaranteed residual is not a financial asset, its disposition affects the expected credit loss calculation.

However, there is an important limitation. While expected gains from asset disposition can reduce the allowance for credit losses, they cannot result in a negative allowance at the pool level. In other words, expected gains should not overstate the credit quality of the lease portfolio. Entities should apply judgment when modeling expected cash flows to ensure compliance with this constraint.

In summary, lessors must include both financial and non-financial components in their CECL analysis for direct financing leases. The unguaranteed residual asset, though not a financial asset, plays a key role in estimating expected credit losses under ASC 326-20.

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Disclaimer: This post is for informational purposes only and does not constitute accounting, legal, or professional advice.

Consult a qualified professional at GLOBAL ABAS Consulting, LLC for guidance specific to your situation.

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