Topic 842 Technical Corrections Summary of Comments Received

Contact(s) David Hoyer Co-Author Ext. 462 Andy Bologna Co-Author Ext. 356 Thomas Faineteau Co-Author Ext. 362 Chris Roberge Co-Author Ext. 274 Amy Park Co-Author Ext. 476 Shayne Kuhaneck Assistant Director Ext. 354 Project Project Stage Issue(s) Leases Implementation Implementation Topic 842 Technical Corrections Summary of Comments Received Memo Purpose 1. The purpose of this memo is to provide a summary of the comments received on Proposed Accounting Standards Update, Technical Corrections and Improvements to Recently Issued Standards: II. Accounting Standards Update No. 2016-02, Leases (Topic 842). 2. The memo is organized as follows: (a) Background Information (b) Summary of Comments Received. Background Information 3. 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. 4. The Board has an ongoing agenda project about technical corrections and improvements to the Codification. The amendments in this proposed Update are of a similar nature to the items typically addressed in that project. However, the Board decided to issue a separate proposed Update for technical corrections and improvements related to Topic 842 and other Topics amended by Update 2016-02 to increase stakeholders awareness of the proposed amendments and to expedite improvements to the amendments in Update 2016-02. Page 1 of 11

5. A proposed Update was issued on September 27, 2017, with comments due by November 13, 2017. The proposed Update included the following three questions: Question 1: Would the amendments in this proposed Update clarify the guidance in Topic 842 or provide a better link between paragraphs within Topic 842 or between the guidance in Topic 842 and other Topics? If not, please explain which proposed amendment(s) you disagree with and why. Question 2: Will any of the proposed amendments result in substantive changes to the application of Topic 842 that would require transition provisions or an effective date for the final amendments other than those noted in the Summary section When Would the Amendments Be Effective? If so, please describe. Question 3: Should other changes that are directly or indirectly related to the proposed amendments be made? Please note that the Board will conduct Codification improvements projects on a periodic basis and additional changes may be postponed to a subsequent Codification improvements project. Summary of Comments Received Overview of Comments 6. There were eight comment letters received on the proposed Update. The following table provides information on the composition of comment letter respondents: Number of Type of Respondent Respondent s Public Accounting Firms 6 State Societies of CPAs 1 Preparers 1 Total Respondents 8 7. In general, respondents largely supported the proposed amendments, but some respondents requested additional clarification on specific proposed amendments. All respondents also generally agreed that the proposed amendments would not result in substantive changes to the application of Topic 842 that would require alternate transition provisions or an alternate effective date for the final amendments, although one respondent raised the possibility that some entities may be affected and could require transition guidance. Lastly, some respondents recommended additional changes in response to Question 3 of the proposed Update, and these changes are addressed later in this document. Page 2 of 11

Support for Proposed Technical Corrections to Topic 842 (Question 1) 8. All respondents generally supported the proposed amendments and expressed the belief that these amendments would clarify the guidance in Topic 842. However, some respondents (all public accounting firms) requested additional clarification on specific issues within the proposed Update. Background and comment letter feedback on these issues are discussed in detail below. Issue 2 Rate Implicit in the Lease 9. Stakeholders had previously raised questions about the treatment of certain sales-type leases with significant variable payments under Topic 842 and whether the application of Topic 842 could result in a negative rate implicit in the lease, rather than a loss at the commencement date of the lease. Based on the Board s decisions on this issue at its June 2017 meeting, the amendments in the proposed Update clarified that the rate implicit in the lease cannot be less than zero. Rate Implicit in the Lease The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used. The rate implicit in the lease, as defined and applied in Topic 842, shall not be less than zero. 10. While the updated definition of rate implicit in the lease would provide clarity from a lessor standpoint (that is, the rate cannot be less than zero), one respondent (public accounting firm) raised a follow-up question from a lessee perspective. The new leases guidance requires a lessee to use the rate implicit in the lease if that rate is readily determinable. Otherwise, the lessee should use its incremental borrowing rate. In leases with significant variable payments, the rate implicit in the lease may be readily determinable by the lessee, and, therefore, the proposed amendment may also result in the use of a zero discount rate by the lessee. Accordingly, that respondent questioned whether this result for the lessee was acceptable to the Board, in which case the Board would not need to take action. Otherwise, the respondent suggested clarifying that the lessee in those situations should use its incremental borrowing rate. Issue 8 Transition Guidance for Amounts Previously Recognized in Business Combinations, and Issue 9 Certain Transition Adjustments 11. Three respondents (public accounting firms) requested clarification, either through changes to the proposed amendments or through an explanation in the basis for conclusions of a final Update, on the interrelated guidance in Issues 8 and 9 as it pertains to certain transition adjustments by lessors for amounts previously recognized in a business combination for an operating lease. Page 3 of 11

12. Specifically, those respondents questioned why the transition adjustments made by a lessor for favorable or unfavorable terms recognized for an operating lease acquired as part of a business combination that becomes classified as a sales-type lease or direct financing lease under Topic 842 are made to equity regardless of the date of the transaction. One respondent (CL #8) also questioned whether there is any net difference to be recorded in those situations. 13. The specific proposed amendments referenced are shown below: > Transition Related to Accounting Standards Update No. 2016-02, Leases (Topic 842)... 842-10-65-1 The following represents the transition and effective date information related to Accounting Standards Update No. 2016-02, Leases (Topic 842)...: Amounts previously recognized in respect of business combinations h. If an entity has previously recognized an asset or a liability in accordance with Topic 805 on business combinations relating to favorable or unfavorable terms of an operating lease acquired as part of a business combination, the entity shall do all of the following: Lessors 1. Derecognize that asset and liability (except for those arising from operating leases for which the entity is a lessor). 2. Adjust the carrying amount of the right-of-use asset by a corresponding amount if the entity is a lessee. 3. Make a corresponding adjustment to equity at the beginning of the earliest comparative period presented if assets or liabilities arise from leases that are classified as sales-type leases or direct financing leases in accordance with Topic 842 840 for which the entity is a lessor. Also see (w). Leases previously classified as operating leases under Topic 840 w. For each lease classified as a direct financing or a sales-type lease in accordance with this Topic, the objective is to account for the lease, beginning on the later of the beginning of the earliest comparative period presented in the financial statements and the commencement date of the lease, as if it had always been accounted for as a direct financing lease or a sales-type lease in accordance with this Topic. Consequently, a lessor shall do all of the following: 1. Derecognize the carrying amount of the underlying asset at the later of the beginning of the earliest comparative period presented in the financial statements and the commencement date of the lease. 2. Recognize a net investment in the lease at the later of the beginning of the earliest comparative period presented in the financial statements and the commencement date of the lease as if the lease had been accounted for as a direct financing lease or a sales-type lease in accordance with Subtopic 842-30 since lease commencement. 3. Record any difference between the amounts in (w)(1) and (w)(2) as an adjustment to equity (if the commencement date of the lease was before the beginning of the earliest period presented or if the lease was acquired as part of a business combination; also see (h)(3)) or earnings (if the commencement date of the lease was on or after the beginning of the earliest period presented). 4. Account for the lease in accordance with this Topic after the later of the beginning of the earliest comparative period presented in the financial statements and the commencement date of the lease. Page 4 of 11

14. Respondents generally sought to better understand why the proposed transition amendments require a lessor to record the transition adjustment to equity only for a business combination. Those respondents noted that, for other items, the Board differentiates between adjustments that should be recorded in profit and loss (for example, nonqualifying initial direct costs incurred during the comparative periods) from adjustments that should be recorded in equity (for example, nonqualifying initial direct costs incurred before the beginning of the earliest period presented). One public accounting firm (CL #2) questioned whether this was done so that entities would not have to adjust goodwill from previous acquisition accounting. Another public accounting firm (CL #6) also suggested language reflecting its belief that any adjustments resulting from favorable or unfavorable terms of an operating lease acquired as part of a business combination would be included in, and offset with, the net investment in the lease being recognized at transition. That respondent suggested to make the following edits to the transition guidance. Amounts Previously Recognized in Respect of Business Combinations h. If an entity has previously recognized an asset or a liability in accordance with Topic 805 on business combinations relating to favorable or unfavorable terms of an operating lease acquired as part of a business combination, the entity shall do all of the following: Lessors 3. See (w) for Make a corresponding adjustment to equity at the beginning of the earliest comparative period presented if assets or liabilities arise from leases that are classified as sales-type leases or direct financing leases in accordance with Topic 840842 for which the entity is a lessor. Leases previously classified as operating leases under Topic 840 w. For each lease classified as a direct financing or a sales-type lease in accordance with this Topic, the objective is to account for the lease, beginning on the later of the beginning of the earliest comparative period presented in the financial statements and the commencement date of the lease, as if it had always been accounted for as a direct financing lease or a sales-type lease in accordance with this Topic. Consequently, a lessor shall do all of the following: 1. Derecognize the carrying amount of the underlying asset as well as any asset or a liability previously recognized in accordance with Topic 805 on business combinations related to favorable or unfavorable terms of a Topic 840 operating lease acquired as part of a business combination at the later of the beginning of the earliest comparative period presented in the financial statements and the commencement date of the lease. Issue 13 Impairment of Net Investment in the Lease 15. Paragraph 842-30-35-3 provides guidance to lessors for determining the loss allowance of the net investment in the lease and describes the cash flows that should be considered when the lessor determines that loss allowance. Stakeholders had previously questioned whether the guidance, as written, would accelerate and improperly measure the loss allowance because the cash flows associated with the unguaranteed residual asset appear to be excluded from the evaluation. Based on Page 5 of 11

the Board s decisions on this issue at its June 2017 meeting, the amendments in the proposed Update clarified the application of the guidance for determining the loss allowance of the net investment in the lease, including the cash flows to consider in that assessment. 842-30-35-3 A lessor shall determine impairment related to the net investment in the lease and shall recognize any impairment in accordance with Topic 310 on receivables (as described in paragraphs 310-10-35-16 through 35-30). When determining the loss allowance for a net investment in the lease, a lessor shall take into consideration the collateral relating to the net investment in the lease. The collateral relating to the net investment in the lease represents the cash flows that the lessor would expect to receive (or derive) derive from the lease receivable and the unguaranteed residual asset underlying asset during and following the end of the remaining lease term (for example, from sale of the asset or release of the asset for the remainder of the lease term), which excludes the cash flows that the lessor would expect to derive from the underlying asset following the end of the lease term (for example, cash flows from leasing the asset after the end of the lease term). 16. One respondent (public accounting firm) requested that the Board clarify that when evaluating impairment of a net investment in a lease, the cash flow assumption after the end of the lease term should not include an adjustment to reflect credit risk. Issue 15 Effect of Initial Direct Costs on the Rate Implicit in the Lease 17. Stakeholders had noted that the ordering of the illustration in Case C of Example 1 in paragraphs 842-30-55-31 through 55-39 raised questions about how initial direct costs factor into determining the rate implicit in the lease for lease classification purposes for lessors only. Accordingly, and based on the Board s decisions on this issue at its June 2017 meeting, the amendments in the proposed Update more clearly aligned that illustration to the guidance in paragraph 842-10-25-4, which states: 842-10-25-4 A lessor shall assess the criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1) using the rate implicit in the lease. For purposes of assessing the criterion in paragraph 842-10-25-2(d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. 18. One respondent (public accounting firm, CL #6) recommended adding language to paragraph 842-10- 25-4 to further clarify that the rate implicit in the lease may be different depending on whether the lease is being assessed for sales-type or direct financing classification, assuming the fair value of the underlying asset differs from its carrying value. That respondent contends that this is a confusing concept for stakeholders, and they strongly recommend that the Board to make the following changes: 842-10-25-4 A lessor shall assess the criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1) using the rate implicit in the lease. For purposes of determining the rate implicit in the lease when assessing the criterion in paragraph 842-10-25-2(d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. Page 6 of 11

Other Issues Mentioned in Comment Letter Feedback 19. There also were additional requests for clarification on the proposed amendments. However, the staff considers those clarification requests to be editorial in nature, and, therefore, those requests are not separately discussed herein. The staff also believes that no action is needed on those requests. Transition Requirements for Proposed Technical Corrections (Question 2) 20. Nearly all respondents agreed that the proposed amendments would not result in substantive changes to the application of Topic 842 and that the proposed amendments would not require transition provisions or an effective date different from those that were proposed. Specifically, for entities that have early adopted Topic 842, the proposed amendments would be effective upon issuance of a final Update, and the transition requirements would be the same as those in Topic 842. For entities that have not adopted Topic 842, the effective date and transition requirements would be the same as the effective date and transition requirements in Topic 842. 21. One respondent (public accounting firm, CL #8) observed that it is unclear how an entity would record any adjustments resulting from applying the proposed amendments if those amendments result in a change from how the entity previously applied the new leases guidance. That is, should an entity apply the amendments prospectively to new transactions or retrospectively to existing transactions? This respondent used an example of an entity that early adopted Topic 842 and applied a negative rate implicit in the lease to account for a direct financing lease with significant variable lease payments that do not depend on an index or a rate. Per the respondent, the proposed amendments do not specify how or whether such an entity should record an adjustment pursuant to finalization of the proposed amendments. Other Amendments Recommended by Respondents (Question 3) 22. In addition to the above issues, respondents brought various other issues to the attention of the Board in their comment letters. These requests are discussed in more detail below. Sale of an Asset with a Repurchase Option Transfer of Control Guidance in Topic 606 versus Topic 842 23. One respondent (public accounting firm, CL #1) drew attention to what it believes is an issue resulting from guidance crossover between Topics 606 and 842. Specifically, paragraph 606-10-55-68 provides guidance for sales of goods subject to a seller repurchase option. This guidance states that in those situations, a customer does not obtain control of the asset; therefore, no sale occurs and no revenue should be recognized. The paragraph then directs the reader to one of two locations for additional guidance, one of which is Topic 840 (or Topic 842), when the repurchase price is for an amount that is less than the original selling price of the asset. Page 7 of 11

> Implementation Guidance > > Repurchase Agreements > > > A Forward or a Call Option 606-10-55-68 If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset. Consequently, the entity should account for the contract as either of the following: b. A lease in accordance with Topic 840 on leases, if the entity can or must repurchase the asset for an amount that is less than the original selling price of the asset unless the contract is part of a sale-leaseback transaction. If the contract is part of a sale-leaseback transaction, the entity should account for the contract as a financing arrangement and not as a sale-leaseback in accordance with Subtopic 840-40. 24. Once in the leases guidance, it is the respondent s understanding that nearly all sales with a repurchase option would be classified as sales-type leases; therefore, the seller would be required to derecognize the asset and recognize a gain. Nearly all sales with a repurchase option will be classified as salestype leases under the new leases guidance because the lease term in those transactions would be equal to the remaining economic life of the sold item because the lease term includes all periods covered by lessor-controlled termination options (the repurchase option in effect is a termination option controlled by the lessor). In addition, the lease payments (the sales price paid by the customer) would equal substantially all the fair value of the underlying asset because the repurchase option price would be excluded from the lease payments consistent with the determination of the lease term (which assumes that the lessor will not exercise its repurchase right). Accordingly, Topic 842 will require the entity to derecognize the asset and recognize a gain when the guidance in Topic 606 provided that the entity had not transferred control of the asset and, therefore, could not recognize revenue. 25. Considering this information, the respondent requested that the Board add language to paragraph 606-10-55-68(a) that would explicitly require entities to account for these transactions as an operating lease, rather than simply as a lease (which would be subject to the lease classification guidance). Alternatively, that respondent suggested that the Board add guidance in Topic 842 in lieu of amending Topic 606 to the extent that the Board does not wish to amend Topic 606. Leases with Variable Payments That Do Not Depend on an Index or Rate Timing of Recognition Guidance in Topic 842 versus Topic 606 26. Three respondents (public accounting firms) requested additional amendments (or clarification in the basis for conclusions of the final Update resulting from these amendments) surrounding lessor accounting for variable payments. Specifically, these respondents pointed to language in paragraph 842-10-15-40: Page 8 of 11

842-10-15-40 If the terms of a variable payment amount other than those in paragraph 842-10-15-35 relate to a lease component, even partially, the lessor shall recognize those payments as income in profit or loss in the period when the changes in facts and circumstances on which the variable payment is based occur (for example, when the lessee s sales on which the amount of the variable payment depends occur). [Emphasis added.] 27. These respondents noted that the above guidance, particularly the emphasized portion, might result in a lessor recognizing revenue for variable payments allocated to the nonlease component in a period that is different from the period in which the nonlease component is transferred to the customer under Topic 606. One respondent (CL #8) also pointed to Example 14 of Subtopic 842-10 s illustration guidance, which states that these payments should be recognized in income when and if earned. In the opinion of that respondent, this language indicates that lessors should still consider guidance in Topic 606 when determining when to recognize income related to these payments. > Implementation Guidance and Illustrations > > Illustrations of Allocating Consideration to Components of a Contract > > > Example 14 > > > > Case A Variable Payments That Relate to the Lease Component and the Non-Lease Component 842-10-55-152 In accordance with paragraphs 842-10-15-39 through 15-40, Lessor also concludes that the potential variable payments should not be accounted for as consideration in the contract. That is because the potential variable payment each year is not solely related to performance of the nonlease maintenance services; the quality and condition of the underlying asset also substantively affect whether Lessor will earn those amounts. Therefore, Lessor s allocation of the consideration in the contract ($300,000) in this Example is the same as Lessee. Lessor, in the same manner as Lessee, also will recognize the income related to the variable payments and allocate that income between the lease and nonlease maintenance services (on the same basis as the initial allocation of the consideration in the contract), when and if earned. 28. Therefore, the three respondents recommended changes to paragraph 842-10-15-40 based on this concern, and two of those respondents (CL #1 and #8, respectively) proposed changes that could be made. 842-10-15-40 If the terms of a variable payment amount other than those in paragraph 842-10-15-35 relate to a lease component, even partially, the lessor shall recognize allocate those payments to the lease and nonlease components of the contract (on the same basis as income the initial allocation of the consideration in profit or loss in the period the contract) when the changes in facts and circumstances on which the variable payment is based occur (for example, when the lessee s sales on which the amount of the variable payment depends occur). Variable lease payments shall be recognized as income in profit or loss in accordance with Subtopic 842-30, while variable payments attributable to nonlease components shall be recognized in accordance with other Topics (for example, Topic 606). Or 842-10-15-40 If the terms of a variable payment amount other than those in paragraph 842-10-15-35 relate to a lease component, even partially, the lessor shall recognize those payments as income in profit or loss in the period when the changes in facts and circumstances on which the variable payment is based occur Page 9 of 11

and when and if the income is earned (for example, when the lessee s sales on which the amount of the variable payment depends occur). 29. One respondent (CL #1) also suggested that if the Board decides not to make this technical correction, the Board explain in the basis for conclusions its intent with respect to the application of paragraph 842-10-15-40. Practical Expedient for Index or Rate During Transition for Initially Measuring Operating Leases 30. One respondent (preparer) requested that the Board provide a practical expedient that would allow entities to use the index or rate in effect at the beginning of the earliest comparative period presented in the financial statements, rather than using the index or rate as applied under Topic 840, when initially measuring existing operating leases. The preparer stated that it has leases with inception dates ranging decades and examining historical data to find the relevant rates may be costly and would not provide users with the most relevant information. Lessor Subsequent Measurement Guidance in Transition for Operating Leases 31. One respondent (public accounting firm) requested that the Board provide subsequent measurement guidance to indicate how a lessor would account for existing leases previously classified as operating leases under Topic 840 that remain operating leases under Topic 842. The respondent noted that similar guidance exists for leases previously classified as direct financing leases or sales-type leases under Topic 840, in addition to guidance for leases previously classified as operating leases under Topic 840 that are classified as a sales-type or direct financing lease under Topic 842. 32. The respondent requested that the Board provide an additional subparagraph within paragraph 842-10-65-1(v) to explain the Board s intent for subsequent measurement accounting in this area, similar to the way it has done this for paragraph 842-10-65-1(x) for other leases situations. Reimbursement of Lessor Costs by Lessees Gross Versus Net Presentation for Lessors 33. One respondent (public accounting firm) recommended that the Board provide a practical expedient for the accounting by lessors surrounding a lessee s reimbursement of a lessor s costs. Paragraph 842-10-15-30 states that reimbursement or payment of the lessor s costs are not components of a contract and do not receive an allocation of the consideration in the contract. For example, a lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement for the lessee to pay those costs, whether directly to a third party or as a reimbursement to the lessor, does not transfer a good or service to the lessee separate from the right to use the underlying asset. 34. The respondent noted that, consistent with the guidance in paragraph 842-10-15-30, real estate taxes and property insurance are not components of the contract. But that respondent described difficulties many lessors will have in estimating these costs for gross presentation in profit or loss when the lessee is responsible for obtaining property insurance in the lessor s name and the lessor does not know those Page 10 of 11

amounts because they are paid directly by the lessee to the third-party insurance company and the lessee is not required to provide that information to the lessor. To comply with the guidance, lessors will need to estimate these costs, over which they may have no control because lessors may not be part of the negotiations and agreement between the lessee and the third-party insurance company. The respondent also argued that the gross up in profit or loss will not provide useful information. Therefore, the respondent recommended that the Board add a practical expedient that would allow lessors to disclose the fact that they cannot estimate the value of these reimbursements, rather than determining some type of estimate for the gross presentation in profit or loss of those lessor costs. Fair Value Rent as an Index or Rate 35. One respondent (public accounting firm) requested that the Board add specific guidance within Topic 842 to clarify that fair value rent should be treated as an index or rate for purposes of determining variable lease payments that should be included in the measurement of the lease liability for lessees or of the lease receivable for lessors. The respondent believed that adding this clarification would prevent diversity in practice that could result from differing interpretations of how fair value rent should be treated under Topic 842. Accounting for Lease Modifications During Transition 36. One public accounting firm expressed their desire that the Board clarify the accounting for lease modifications that occur during the transition period. According to the respondent, the guidance is clear that Topic 842 should be applied to modifications occurring on or after the effective date of that Topic, in addition to reassessments by lessees. However, the guidance is less clear about modifications and reassessments that occur during the comparative periods, and the distinction is important because the guidance in Topics 840 and 842 differ significantly. Interim Disclosure Requirements 37. One respondent (public accounting firm) requested that the Board formally clarify in Topic 842 whether entities should provide the Topic 842 disclosures on an interim basis in addition to the annual basis. Other Issues Mentioned in Comment Letter Feedback 38. There also were additional requests for amendments to Topic 842. However, the staff has considered these requests and believes that no Board action is necessary at this time. Therefore, these requests are not discussed individually in this document. Page 11 of 11