Lease & Finance Accountants Conference September 11-13 The Westin Charlotte Charlotte, NC H A N D O U T S
Lessor Accounting under ASC 842 EQUIPMENT LEASING AND FINANCE ASSOCIATION
Presenters Rod Hurd Chief Financial Officer Bridgeway Capital Advisors, Inc. rhurd@bwaycap.com Bob Malinowski Executive Director EY Financial Accounting Advisory Services Bob.malinowski@ey.com.com
Lease classification considerations EQUIPMENT LEASING AND FINANCE ASSOCIATION
Lease classification A lease is classified* as a sales-type lease if it meets any criteria below: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise The lease term is for the major part**of the remaining economic life of the underlying asset* 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 equals or exceeds substantially all** of the fair value of the underlying asset 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 lease term *Lease classification tests are performed at lease commencement, as opposed to lease inception under ASC 840. ** Major part and substantially all intended to adopt principle-based approach of IAS 17; however, preparers can retain the 75% and 90% bright lines by making an accounting policy election.
Lease classification Does the lease meet any one of the classification criteria on the previous page? No Does the lease meet both of the following criteria? The present value of the sum of lease payments and any residual value guaranteed by the lessee and another third party unrelated to the lessor equals or exceeds substantially all the fair value of the underlying asset It is probable that the lessor will collect the lease payments plus any amounts necessary to satisfy a residual value guarantee Yes Yes No Sales-type lease* Direct financing lease Operating lease * ASC 842 does not require lessors to assess the collectibility of lease payments and any residual value guarantee provided by the lessee in the sales-type lease classification test. However, lessors are required to assess the collectibility of lease payments and any residual value guarantee provided by the lessee to determine the recognition and initial measurement of sales-type leases.
Collectibility Sales-type Direct financing Operating Collectibility is probable Derecognize the underlying asset Derecognize the underlying asset Continue to recognize the underlying asset Recognize the net investment in the lease Recognize any selling profit or loss Recognize the net investment in the lease Recognize any selling loss Defer any selling profit and include it in the initial measurement of the net investment in the lease Collectibility assessment affects subsequent measurement Collectibility is not probable Do not derecognize the underlying asset Classify as an operating lease if collectibility is not probable Account for lease payments received as a deposit liability
Fair value The definition of fair value in ASC 820, Fair Value Measurement, is used to determine the fair value of the underlying asset The fair value of the underlying asset in a lease arrangement is the price that would be received to sell the asset in an orderly transaction between market participants at the measurement date ASC 842 aligns the definition of fair value used for lease transaction to the detention of fair value under ASC 820. The updated definition of fair value may potentially have impacts that relate to: Lease classification Treatment of transaction costs and transfer taxes The updated definition of fair value may potentially have impacts that relate to lease classification and/or treatment of transaction costs and transfer taxes
Initial direct costs (IDCs) Only incremental costs qualify as IDCs (conforms with ASC 606) Incremental costs are those that would not have been incurred if the lease had not been obtained (e.g., commissions, payments made to an existing tenant to incentivize that tenant to terminate its lease) Lessors* Lease classification Sales-type lease if the fair value of the underlying asset is different from its carrying amount at lease commencement Sales-type lease if the fair value equals the carrying value of the underlying asset at lease commencement Direct financing lease Operating lease Lessor Accounting for capitalized IDCs Expense IDCs at lease commencement Include IDCs in the initial and subsequent measurement of the net investment in the lease Recognize IDCs as an expense over the lease term on the same basis as lease income * For purposes of performing the sales-type lease classification test only, a lessor assumes that no IDCs will be deferred (i.e., IDCs are excluded from the calculation of the rate implicit in the lease) if, at the commencement date, the fair value of the underlying asset is different from its carrying amount Fewer costs will qualify as IDCs under ASC 842
Implicit rate To determine the present value of lease payments, lessors use the rate implicit in the lease that causes the following: The present value of lease payments made by the lessee for the right to use the underlying asset The present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term The fair value of the underlying asset minus any related + = + investment tax credit retained and expected to be realized by the lessor Any deferred initial direct costs of the lessor* * When performing a sales-type lease classification test only, a lessor excludes initial direct costs from the calculation of the rate implicit in the lease if the underlying asset s fair value differs from its carrying value at lease commencement The definition of implicit rate differs from ASC 840 by including IDCs in the calculation and potentially by changes to the definition of fair value
Lease payments Lease payments should be consistent with the lease term Lease payments Fixed (including in-substance fixed) payments, less any lease incentives paid or payable to the lessee Variable payments based on an index or rate Exercise price of a purchase option* Payments for penalties for terminating the lease** Amounts it is probable that the lessee will owe under residual value guarantees (lessees only) * Include only if reasonably certain of exercise ** Include only if the lease term reflects the lessee exercising an option to terminate the lease If a lease arrangement includes significant variable lease payments that do not depend on an index or rate, the net investment in the lease recognized may be lower than the carrying amount of the underlying asset at lease commencement. In these cases, the difference between the initially recognized net investment in the lease and the carrying amount of the underlying asset derecognized is recognized as a selling loss.
Treatment of executory costs Gross Lease Net Lease Current practice Lessor pays for taxes and insurance Lessor recognizes rental income related to gross rent received from lessee Lessor expenses payments for taxes and insurance Lessee pays for taxes and insurance directly or Lessor pays amounts and bills lessee Lessor recognizes rental income related to net rent received from lessee No change Future requirements FASB has indicated that Lessors recognize income and expense on a gross basis related to taxes / insurance that are paid by the lessee Grossing up the income statement for executory costs paid by lessees under net leases could result in significant changes to the income statement as well as involve operational challenges
Multi-element arrangements EQUIPMENT LEASING AND FINANCE ASSOCIATION
Determining whether an arrangement contains a lease EQUIPMENT LEASING AND FINANCE ASSOCIATION
Multi-element arrangements Many contracts contain a lease coupled with an agreement to purchase or sell other goods or services (non-lease components) Non-lease components (e.g., maintenance activities, including common area maintenance) are identified and accounted for separately from the lease component in accordance with other US GAAP (i.e., as executory arrangements by lessees or as contracts subject to ASC 606, Revenue from Contracts with Customers, by lessors) As a practical expedient, lessees can make an accounting policy election (by class of underlying asset) to account for each separate lease component of a contract and its associated non-lease component(s) as a single lease component Some contracts contain items that do not relate to the transfer of goods or services by the lessor to the lessee (e.g., fees or other administrative costs that a lessor charges a lessee, payments for insurance that protects the lessor s asset, taxes related to the lessor s asset) These items should not be considered separate lease or non-lease components Lessees and lessors do not allocate consideration in the contract to these items
Determining consideration The payments described as lease payments + Any other fixed payments (e.g., monthly service charges) or in-substance fixed payments made during the lease term, less any incentives paid or payable to the lessee + Any other variable payments that depend on an index or a rate made during the lease term and initially measured using the index or rate at the commencement date + Consideration in the contract for a lessee Any other variable payments that would be included in the transaction price in accordance with the guidance on variable consideration in ASC 606 that specifically relate to either of the following: The lessor s efforts to transfer one or more goods or services that are not leases An outcome from transferring one or more goods or services that are not leases = Consideration in the contract for a lessor
Allocating consideration Lessors generally apply ASC 606 to allocate consideration in the contract to lease and non-lease components on a relative standalone selling price basis, except when allocating certain discounts and certain variable consideration Lessors allocate variable payments accounted for as consideration in the contract entirely to the non-lease component(s) to which they specifically relate if doing so would be consistent with the transaction price allocation objective in ASC 606 If this allocation is not consistent with the allocation objective in ASC 606, the consideration in the contract is generally allocated between lease and non-lease components on a relative standalone selling price basis Lessors allocate variable payments excluded from the consideration in the contract between lease and non-lease components on the same basis as the allocation of the consideration in the contract Lessors recognize those payments as income in the period when both: (1) the changes in facts and circumstances on which the variable payments are based occur and (2) the variable payments are earned
Sale-leaseback and build-to-suit EQUIPMENT LEASING AND FINANCE ASSOCIATION
Sale-leaseback transactions Key changes between ASC 840 and ASC 842: Elimination of distinction between real estate and equipment Gains recognized at time of sale, not deferred A seller-lessee and a buyer-lessor apply ASC 842 (leases) and ASC 606 (revenue recognition) when determining whether the transfer of an asset should be accounted for as a sale and purchase Sale and leaseback transactions no longer provide seller-lessees with a source of offbalance sheet financing, but may provide lower initial expense for operating leases More real estate sale and leaseback transactions are expected to be accounted for as sales and leasebacks under ASC 842 than under ASC 840 due to the elimination of the real estate-specific requirements in today s sale and leaseback accounting guidance. Fewer equipment sale-leasebacks may be recognized as sales due to purchase options.
Sale-leaseback transactions Current guidance New guidance Sale-leaseback transactions involving real estate and integral equipment are subject to strict prohibition of any prohibited form of continuing involvement. Examples of prohibited forms of continuing involvement include: Seller purchase option or lessor put Seller guarantee of return Seller provided collateral or nonrecourse financing Seller opportunity to participate in property appreciation The following circumstances would preclude a sale: Leaseback is a finance lease Seller-lessee has a substantive repurchase option Repurchase options at fair value (at exercise) would not preclude sale if asset is both: non-specialized readily available in the marketplace Seller-lessee purchase options of real estate (even at FV) or any fixed price purchase option would preclude sale treatment
Sale-leaseback transactions Current guidance New guidance If a sale-leaseback does not qualify for sale accounting treatment, the seller lessee accounts for the transaction as a: Financing; and sometimes under The deposit method Both require that the: Asset be retained on balance sheet as an owned asset Proceeds be treated as a liability No impact on buyer-lessor accounting (both seller and buyer show asset as owned) If a sale-leaseback does not qualify for sale accounting treatment, both lessors and lessees would account for transaction as a financing Seller-lessee continues to report asset with proceeds reflected as a borrowing and lease payments as debt service Buyer-lessor would likely not reflect a PPE asset, but a receivable accounted for under the effective interest method and amortized down to the asset residual value
Sale-leaseback transactions Seller-lessee Accounting for the sale Recognizes the transaction price for the sale in accordance with ASC 606 Derecognizes the carrying amount of the underlying asset Recognizes any gain or loss, adjusted for off-market terms, immediately Accounting for the leaseback Same manner as other operating leases, adjusted for off-market terms Additional disclosure requirements Recognizes a financing liability Accounting for the purchase Recognizes the asset in accordance with ASC 360 Property, Plant, and Equipment Accounting for the leaseback Same manner as other direct financing or operating leases, adjusted for off-market terms Initial direct costs capitalized in connection with ASC 842 guidance Recognizes a loan receivable Transaction costs capitalized based on guidance for lending activities Buyer-lessor Sale and leaseback transaction accounting Financing transaction accounting (failed sale and leaseback) Refer to Example 2 in ASC 842-40-55-31->39 for example of financing method
Build-to-suit transactions Change in paradigm for build-to-suit lease arrangements from risks and rewards model to control model Existence of onerous rules in ASC 840-40-55 requiring a lessee to consider itself the owner of an asset for accounting purposes prior to lease commencement (irrespective of whether it held title) A lessee considered the owner of the asset prior to lease commencement (i.e. during a construction period) will reflect the asset on its balance sheet and must apply the sale leaseback guidance at the end of a construction period to determine whether the asset may be derecognized and a lease classified ASC 842 changes the focus to whether the lessee controls the asset being constructed rather than whether the lessee has substantially all of the risks during the construction period Currently unclear whether ASC 842 build-to-suit guidance will be applicable to lessors
Build-to-suit transactions The following examples demonstrate (individually or in the aggregate) that the lessee controls an underlying asset that is under construction: The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (e.g., by making a payment to the lessor) The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use to the owner-lessor The lessee legally owns the land and property improvements (e.g., building on the land) or the non-real estate asset (e.g., ship) that is under construction The lessee controls the land that property improvements will be constructed on and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements The lessee leases the land that the property improvements will be constructed on and the term of the lease (together with lessee renewal options) is for substantially all of the economic life of the property improvements, and the lessee does not sublease the land before the beginning of construction for the same time period (or longer) than the lessee controls the land
Build-to-suit transactions Does the lessee control the underlying asset being constructed before the commencement date? Yes No ASC 842 does not provide specific recognition and measurement guidance It is expected that an entity will: Recognize the asset as costs are incurred Recognizes a liability in an amount equal to the capitalized costs not paid for by the lessee When lease commences, evaluates the sale and leaseback guidance in ASC 842 and ASC 606 Evaluates the nature of the payments made or costs incurred prior to the commencement date (see next page for the accounting of these payments or costs)
Other revenue recognition issues EQUIPMENT LEASING AND FINANCE ASSOCIATION
Other revenue recognition issues Sales of assets subject to operating leases Current requirements Post-adoption of ASC 606 The sale of property subject to an operating lease, or property that is leased or intended to be leased by the third-party purchaser, shall not be treated as a sale when the seller retains substantial risks of ownership. The sale of property subject to an operating lease, or property that is leased or intended to be leased by the third-party purchaser, shall not be treated as a sale when the seller does not transfer control of the asset to the buyer in accordance with ASC 606-10-25-30.
Other revenue recognition issues Sales of assets to a dealer when the assets may be repurchased from by a captive finance subsidiary Current requirements Post-adoption of ASC 606 A seller may recognize a sale to a dealer if certain criteria are met. ASC 606 not anticipated to impact sale treatment
Other revenue recognition issues Sales of assets with residual value guarantee to buyer or repurchase obligation Current requirements Post-adoption of ASC 606 A seller is precluded from recognizing a sale of equipment if the seller guarantees the resale value of the equipment to the purchaser, and should account for the arrangement as a lease. Sales that include repurchase obligations will be recorded accounted for as either a lease or a financing Residual value guarantees subject to guarantee accounting requirements