Chapter 4

Real Estate Leases

4.1 Overview

What agreements are considered leases? Topic 840, Leases (Financial Accounting Standards Board (FASB) Statement No. 13, Accounting for Leases), defines a lease as an agreement conveying the right to use property, plant, or equipment (land or depreciable assets or both) usually for a stated period of time.¹

Agreements that transfer the right to use property, plant, or equipment meet the definition of a lease even though substantial services by the lessor may be called for in connection with the operation or maintenance of the asset under lease. The evaluation of whether an arrangement contains a lease within the scope of Topic 840 (Statement No. 13) is based on the substance of the transaction rather than its legal form. An agreement may not be designated as “lease” but nevertheless meet the definition of a lease, such as a heat supply contract for nuclear fuel.² Similarly, certain agreements designated as “leases” may not meet the definition of a lease. The accounting guidance for leases does not apply to lease agreements related to the rights to explore for or to exploit natural resources, such as oil, gas, minerals, or timber; or to licensing agreements for items such as motion picture films, plays, manuscripts, patents, and copyrights.³

Topic 840 (Statement No. 13) provides the basic framework for determining whether a contract is within its scope. Before the issuance of Emerging Issues Task Force (EITF) Issue No. 01-8, Determining Whether an Arrangement Contains a Lease, that determination was largely judgmental. With the issuance of EITF Issue No. 01-8 in 2003, the standard-setters have provided specific guidance to be considered when making that determination.⁴ Besides the typical lease arrangement, in which a piece of equipment or real property is leased for a certain period of time, a lease also encompasses other contractual arrangements that may meet the definition of a lease:

The accounting for leases reflects the view that a lease that transfers substantially all of the benefits and risks of ownership should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee (capital lease) and as a sale or financing by the lessor (sales-type, direct financing, or leveraged lease). Other leases should be accounted for as operating leases, that is, the rental of property.⁵ See Exhibit 4.1. The existing lease model is applied to both lessee and lessor and often leads to symmetrical lease classification.

Before it was codified, the accounting literature pertaining to leases was very fragmented. Several FASB Statements (FASs), Technical Bulletins (TBs), EITF Issues, and FASB Staff Positions (FSPs) provided rule-driven, bright-line guidance on how to account for leasing transactions, often in a narrow context. In spite of the detailed guidance, accounting for leases (mainly the accounting for lease incentives and rent holidays) resulted in hundreds of restatements on the books of retailers and restaurants in early 2005.

Additionally, since the introduction of the variable interest entity consolidation model, companies have to evaluate whether, through their leasing arrangements, they hold variable interests in variable interest entities. Particularly in situations in which single-purpose entities are used in structuring leases, the application of the variable interest entity consolidation guidance may have a significant impact on the accounting and financial statement disclosures.

On the Horizon

The FASB and the International Accounting Standards Board (IASB) have recognized the need for revised accounting guidance related to leases—primarily the operating lease model for lessees was subject to frequent criticism—and “Leases” was added to the agendas of both the FASB and the IASB in July 2006. In this joint project of the FASB and the IASB, the boards have reconsidered many aspects of lease accounting for both lessee and lessor. An exposure draft (Leases ED) was published in August 2010. More than 700 comment letters were received, indicating the vivid interest of the financial community in lease accounting. As a result of the comments received, the boards have been redeliberating many aspects of the proposed guidance, including the proposed lease model for the lessor.

A brief summary highlighting the basic concepts of the proposed lease model,⁶ together with recent tentative decisions reached by the boards,⁷ follows.

Proposed Model—Lessee.⁸

Conceptually, a lessee has acquired a right to use the asset under lease and has entered into an obligation to make lease payments. Under the proposed model, a right-of-use asset would initially be recorded at the present value of lease payments. It would then be amortized over the life of the lease and subject to impairment testing.⁹ The lease liability would be accounted for like a loan (amortization of the liability amount and recording of interest expense).

All leases would be accounted for the same way; there would be no more distinction between operating and capital (finance) leases.

Proposed Model—Lessor.¹⁰

Under the proposed model, the lessor's accounting would be based on the lessor's exposure to risks or benefits of the underlying asset:

The balance sheet and income statement impact of the two approaches is depicted in Exhibit 4.2.

Short-term Leases—Lessee and Lessor.

The boards have tentatively decided to provide an exception for short-term leases:¹¹ For short-term leases, lessees and lessors may elect (as an accounting policy) for a class of underlying assets, to account for all short-term leases by not recognizing lease assets or lease liabilities; and to recognize lease payments in profit or loss on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern in which use is derived from the underlying asset.

Scope.

The scope of the proposed Lease guidance would remain largely unchanged as compared to current U.S. generally accepted accounting principles (GAAP). The IASB and the FASB tentatively decided that leases of intangibles are not required to be accounted for in accordance with the leases standard.¹² The proposed Leases standard includes a scope exception for lessors of investment properties that report under International Financial Reporting Standards (IFRS) and measure their investment properties at fair value. Some arrangements in the legal form of a lease represent in substance the purchase or sale of the underlying asset; however, the boards tentatively decided not to provide guidance for distinguishing a lease from a purchase or a sale.

Lease Term.

The boards tentatively decided that the lease term is the noncancelable period for which the lessee has contracted with the lessor to lease the underlying asset, together with any options to extend or terminate the lease when there is a significant economic incentive for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease. Lessee and lessor should reassess the lease term only when there is a significant change in relevant factors, such that the lessee would then either have, or no longer have, a significant economic incentive to exercise any options to extend or terminate the lease.

Purchase Options.

The boards tentatively decided that lessees and lessors should include the exercise price of a purchase option in the measurement of the lessee's liability to make lease payments and the lessor's right to receive lease payments, if the lessee has a significant economic incentive to exercise the purchase option.

Variable Lease Payments and other Lease Payment Considerations.

The boards tentatively decided which variable lease payments should be included in a lessee's liability to make lease payments and the lessor's right to receive lease payments. The lessee's liability and the lessor's receivable should include:

At the time this publication went to print, there were still a number of unresolved issues that the boards intended to deliberate before the issuance of a final standard. Accordingly, the boards may reach decisions different from what has been described in this section; particularly with respect to the proposed model for lessors, the changes could be significant.

4.2 Definition of a Lease

A lease¹³ is an agreement that conveys:

When specific property is explicitly identified and the benefits of that property are conveyed based on time, the contract likely contains a lease. The difficulty in determining whether an arrangement contains a lease arises when the right to use property is conveyed in some other manner, such as granting the right to the output of the property.

4.2.1 Right to Use

Topic 840 (EITF Issue No. 01-8) provides three conditions that need to be evaluated when determining whether a right to use has been conveyed. If any of these conditions is met, a right to use has been conveyed. Accounting Standards Codification (ASC) 840-10-15-6 (paragraph 12 of EITF Issue No. 01-8), the concept of which is depicted in Exhibit 4.3, states:

An arrangement conveys the right to use property, plant, or equipment if the arrangement conveys to the purchaser (lessee) the right to control the use of the underlying property, plant, or equipment. The right to control the use of the underlying property, plant, or equipment is conveyed if any one of the following conditions is met:

In many contracts for the purchase of products or services, an evaluation has to be made as to whether the payments are made for products or services purchased or whether in essence part or all of the payments are made for the time that property, plant, or equipment is made available to produce the products or services. For example, a power purchase agreement under which Party A obtains all of the electricity produced by a specified power plant may convey to Party A the right to use the power plant, based on the criteria outlined previously. In that circumstance, the purchaser of the power would be deemed to have a lease in place; part of the payments under the power purchase arrangement would be accounted for as lease payments, and a portion would be either (1) a payment for electricity, or (2) a payment for inputs to produce power. Both alternatives (1) and (2) have developed in practice.

Take-or-pay arrangements may commit the purchaser to pay the supplier irrespective of whether the purchaser actually uses a plant or whether the purchaser obtains the output from a plant. In these circumstances, rather than solely constituting a payment for the output from the plant, the purchaser's payments may include a lease component for the right to use the plant. Depending on the terms of the contractual arrangement, the contract may be within the scope of Topic 840 (FASB Statement No. 13).¹⁴

4.2.2 Specified Property, Plant, or Equipment

Topic 840 (FASB Statement No. 13) applies to contracts that convey the use of specified property, plant, or equipment. ASC 840-10-15-15 (paragraph 9 of EITF Issue No. 01-8) explains:

Because a lease is defined as conveying the right to use property, plant, or equipment (land and/or depreciable assets), inventory (including equipment parts inventory) and minerals, precious metals, or other natural resources cannot be the subject of a lease for accounting purposes because those assets are not depreciable. This Topic does not apply to lease agreements concerning the rights to explore for or to exploit natural resources such as oil, gas, minerals, timber, precious metals, or other natural resources. Similarly, intangibles such as workforce and licensing agreements for items such as motion picture films, plays, manuscripts, patents, and copyrights are not deemed the subject of a lease for accounting purposes even though those assets may be amortized.

A contract that conveys the right to use property, plant, or equipment is not necessarily a lease, if the lessor has the choice of which property, plant, or equipment to use to fulfill its contractual obligations. The determination of whether specified property, plant, or equipment has to be used to fulfill the contractual obligations is not an issue in a typical lease arrangement, such as the lease of a building. However, in arrangements that provide for the delivery of products, such as take-or-pay contracts, that determination often requires an in-depth analysis. The identification of the property in the arrangement need not be explicit; it may be implicit. An example is provided in ASC 840-10-55-26 (EITF Issue No. 01-8):¹⁶

. . . in the case of a power purchase contract, if the seller of the power is a special-purpose entity that owns a single power plant, that power plant is implicitly specified in the contract because it is unlikely that the special-purpose entity could obtain replacement power to fulfill its obligations under the contract because a special-purpose entity generally has limited capital resources. Similarly, in the case of a throughput contract, the seller may have only a single pipeline and the prospect of obtaining access to a second pipeline may not be economically feasible. In that circumstance, the seller's pipeline is implicitly specified in the contract.

4.2.3 Stated Period of Time

Rights to use specified property are leases if they convey the right to use the property, plant, or equipment for a stated period of time. A contract that conveys the right to use property, plant, or equipment is within the scope of Topic 840 (FASB Statement No. 13), even if no period of time is explicitly stated in the contract if the terms of the contract specify another measure of use, such as number of units produced.

However, if a contract conveys the right to use property in perpetuity, such as an easement, the arrangement is not within the scope of Topic 840 (Statement No. 13).

4.2.4 Reassessment of the Arrangement

The determination of whether an arrangement conveys the right to use specified property, plant, or equipment (i.e., whether it is within the scope of Topic 840 (FASB Statement No. 13)) is made at the inception of the arrangement. A reassessment has to be made (and can only be made) in four circumstances:¹⁸

That reassessment is made (and would impact the accounting) on a prospective basis.

Exercise of a Renewal Option or Extension of the Term of the Arrangement.²⁰

A renewal or extension of the term of the arrangement that does not include a modification of other terms of the arrangement triggers a reassessment of the arrangement, with this exception: The exercise of a renewal option that was included in the lease term at the inception of the arrangement is not considered a renewal for the purpose of reassessing the arrangement.

A reassessment may impact the accounting for the renewal or extension period; the accounting for the remaining period of the original arrangement is not impacted.

Change in the Determination as to Whether Fulfillment Is Dependent on Specified Property, Plant, or Equipment

If an arrangement was initially determined to include a lease because fulfillment of the arrangement was initially dependent upon specific property, plant, or equipment and an event or events occurred subsequent to the inception of the arrangement such that fulfillment was no longer dependent on the specific property, plant, or equipment (e.g., an active market for the product has developed subsequent to inception of the arrangement), the arrangement would be reassessed to determine if the arrangement contains a lease as of the date that the arrangement is no longer dependent upon specific property, plant, or equipment.

An example would be a supplier that has one facility and decides to build a second facility to increase its production capacity; in that situation, the fulfillment of the supplier's obligations to provide certain products may no longer be dependent on the first facility.

Substantial Physical Change to the Specified Property, Plant, or Equipment

A substantial physical change to the specified property, plant, or equipment may also lead to a reassessment event as to whether the contract contains a lease, depending on the facts and circumstances.

4.3 Lease Classification—General

The classification of leases involving real estate builds on the general lease classification criteria established by Topic 840 (Statement No. 13) for all leases.

The lease classification criteria are generally applied on an asset-by-asset basis, with functionally interdependent equipment (such as computer desktop, monitor, and keyboard) being considered one asset. Topic 840 (Statement No. 13) does not provide for the application of the lease classification criteria to groups of assets.

The classification of a lease is determined at lease inception (which is the date of the lease agreement or commitment, if earlier)²² and not at the beginning of the lease term. For accounting purposes, the beginning of the lease term is the date the lessee takes physical possession of the leased asset, which does not necessarily coincide with the beginning of the lease term stated in the lease agreement (see Exhibit 4.4).

4.3.1 Lease Classification—Lessee

From the perspective of the lessee, a lease is classified as either:

A lease that transfers substantially all of the benefits and risks of ownership is accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee (capital lease). All other leases are accounted for as operating leases, that is, the rental of property. Topic 840 (FASB Statement No. 13) contains certain bright lines that establish when a lease is deemed to have transferred substantially all of the benefits and risks of ownership. If a particular lease meets any one of the four criteria listed below,²³ it is classified as a capital lease:

Minimum lease payments are the payments that the lessee is obligated to make or can be required to make in connection with the leased property.²⁵ For purposes of computing the present value of rental and other minimum lease payments, a lessee should use its incremental borrowing rate,²⁶ unless two conditions apply:

If the lessee has knowledge about the implicit rate computed by the lessor and the lessor's rate is lower than the lessee's incremental borrowing rate, the lessor's implicit borrowing rate is used. Using the lower implicit rate of the lessor rather than the lessee's incremental borrowing rate results in a higher amount of present value of minimum lease payments; it increases the likelihood that the 90% of fair value test leads to capital lease classification.

If none of the four criteria listed in the overview is met, the lease is classified as an operating lease by the lessee. Often, lease agreements are purposefully structured around these thresholds established by ASC 840-10-25-1 (paragraph 7 of Statement No. 13) to achieve a certain lease classification—generally, operating lease classification—and corresponding accounting treatment.

4.3.2 Lease Classification—Lessor

From the lessor's perspective, a lease is classified as:

A lease that transfers substantially all of the benefits and risks of ownership is classified as sales-type lease if the lease gives rise to a manufacturer's or dealer's profit, or as direct financing or leveraged lease if the lease does not give rise to a manufacturer's or dealer's profit. Other leases are accounted for as operating leases (i.e., the rental of property). A lessor does not have to be a dealer to realize a “dealer's” profit (or loss) on a transaction. For example, if a lessor leases an asset that at the inception of the lease has a fair value that is greater or less than its carrying amount, such transaction may be a sales-type lease, assuming the other criteria for a sales-type lease are met.²⁸

Leases are classified as sales-type, direct financing, or leveraged leases if they meet one or more of the criteria for capital leases for lessees (Lease Classification Criteria (Lessee) 1 through 4) and both of the following criteria:²⁹

For purposes of computing the present value of rental and other minimum lease payments, a lessor should use the interest rate implicit in the lease.³⁰

A leveraged lease is a direct financing lease that additionally has all of these characteristics:³¹

ASC 840-30-55-39 through 55-60 (Appendix E of FASB Statement No. 13) include illustrations of accounting for leveraged leases.

4.3.3 Lease Classification Criteria

As discussed in Section 4.3.1, the classification of leases is based on four criteria:³³

If any one of these criteria is met, a lease meets the definition of a capital lease and is capitalized by the lessee. The period over which the leased asset is amortized depends on the lease classification criterion that resulted in the classification as capital lease. If the lease is classified as capital lease, because of transfer of ownership or bargain purchase option, the leased asset is amortized over the estimated useful life of the leased asset.³⁴ If the lease qualifies as a capital lease because it meets either the 75% of economic life test or the 90% of fair value test (or both of these criteria) at the inception of the lease, the asset is amortized over the lease term.³⁵

4.3.3.1 Transfer of Ownership

Topic 840 (FASB Statement No. 13) provides that a lease that transfers ownership of the property at the end of the lease is classified as a capital lease by the lessee. The transfer-of-ownership criterion is also met in situations in which the lease agreement provides for the transfer of title at or shortly after the end of the lease term in exchange for the payment of a nominal fee, such as the minimum fee required by statutory regulation to transfer ownership.³⁶

However, if the terms of the lease specify that ownership of the leased asset is not transferred if the lessee elects not to pay a specified fee, the criterion of transfer of ownership would not be considered met.³⁷

4.3.3.2 Bargain Purchase Option

When is an option a bargain purchase option? ASC 840-10-20 (paragraph 5(d) of Statement No. 13) defines a bargain purchase option as a “provision allowing the lessee, at his option, to purchase the leased property for a price that is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at lease inception, to be reasonably assured.” The estimated fair value of the leased property at the date the bargain purchase option becomes exercisable is based on price levels and market conditions at the inception of the lease and does not include the impact of inflation. When determining whether the exercise of a purchase option is reasonably assured, one would consider, for example:

Purchase options that are reasonably assured of exercise for factors other than price (or penalty provisions in the lease agreement) are also considered bargain purchase options; in certain situations, a lessee may incur costs or economic penalties³⁸ in such amount that the exercise of the purchase option appears reasonably assured at the inception of the lease. That is, an economic disincentive may create a bargain purchase option.

Factors to be considered in the evaluation whether a bargain purchase option exists could include:

Topic 840 (Statement No. 13) does not provide any specific criteria to be considered in making the evaluation whether economic penalties are present that make the exercise of a purchase option reasonably assured; that evaluation depends on the facts and circumstances and is subject to significant judgment.

4.3.3.3 Lease Term

Determining the appropriate lease term is critical for arriving at the appropriate lease classification, since the lease term impacts the assessment under the 75% of economic life test as well as the 90% of fair value test.

The lease term is comprised of:³⁹

Notwithstanding these factors, the lease term would never extend beyond the date a bargain purchase option becomes exercisable.

4.3.3.4 Minimum Lease Payments

The components of the minimum lease payments differ depending on whether they are being evaluated from the lessor's or the lessee's perspective.

Minimum Lease Payments: Lessee's Perspective

Minimum lease payments are payments the lessee is obligated to make or can be required to make in connection with the leased property.⁴³ They include the minimum rental payments, any guarantee of residual value by the lessee, and any payments the lessee can be required to make upon failure to renew or extend the lease term. If the lease includes a bargain purchase option, the amount required to be paid under the bargain purchase option is also included in the minimum lease payments. Minimum lease payments exclude any unguaranteed residual value; the portion of the lease payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor; and any profit thereon. If the portion of the minimum lease payments representing executory costs, including profit thereon, is not determinable from the provisions of the lease, the amount is estimated.

Components of Minimum Lease Payments: Lessee's Perspective
Minimum rental payments
Plus: Residual value guarantee
Plus: Penalties for failure to renew the lease
Plus: Payment for exercise of bargain purchase option
Plus: Other payments the lessee can be required to makea
Minimum lease payments
a Other than executory costs and profit thereon

Minimum Lease Payments: Lessor's Perspective

When evaluated from the lessor's perspective, minimum lease payments include, in addition to the components from the lessee's perspective, just described, any guarantee of the residual value or of rental payments beyond the lease term by a party that is unrelated to either lessee or lessor, provided that third party is deemed financially capable of performing under that guarantee.⁴⁴

Discount Rate to Be Used

Regarding discount rates to be used when computing the present value of the minimum lease payments, Topic 840 (FASB Statement No. 13) prescribes:⁴⁵

The following two examples depict some common provisions in leases and their impact on the calculation of minimum lease payments.

 

4.4 Lease Classification—Leases Involving Real Estate

Leases involving real estate are categorized based on the general lease classification criteria for leases as:

For a lease involving real estate with a fair value different from its carrying amount, the lease is classified as a sales-type lease only if the lease transfers ownership of the property to the lessee by the end of the lease term. Otherwise, such lease is classified as operating lease.

Leases involving real estate can be divided into four categories:⁴⁹

Additionally, special accounting rules apply to leases involving facilities owned by governmental units.⁵⁰

4.4.1 Leases Involving Land Only

4.4.1.1 Leases Involving Land Only: Lease Classification—Lessee

If land is the sole item of property leased, and either of the following criteria are met:

the lessee accounts for the lease as a capital lease, otherwise as an operating lease. Criteria 3 (75% of economic life test) and 4 (90% of fair value test) are not applicable to land leases.

4.4.1.2 Leases Involving Land Only: Lease Classification—Lessor

Transfer of Title.⁵¹

If land is the sole item of property leased and the criterion of transfer of title is met, the lessor classifies the lease as a sales-type lease for property whose fair value at the inception of the lease is greater or less than its carrying amount.

If the criterion of transfer of title is met for property whose fair value at the inception of the lease is equal to its carrying amount, the lessor accounts for the lease either as a direct financing lease or as a leveraged lease, if both of these criteria are met:

If the lease does not meet both of these criteria, the lessor accounts for the lease as an operating lease.

Bargain Purchase Option

Land for which the fair value does not equal its carrying amount is always classified as an operating lease by the lessor, unless the lease provides for a transfer of title.

Land with fair value equal to its carrying amount, for which the lease agreement contains a bargain purchase option, is classified as a direct financing lease or as a leveraged lease, if both of these criteria are met:

If the lease does not meet these two criteria, the lessor accounts for the lease as an operating lease.⁵²

Criteria 3 and 4

Criteria 3 and 4 (75% of economic life test; 90% of fair value test) are not applicable to land leases.⁵³

4.4.2 Leases Involving Land and Building

4.4.2.1 Leases Involving Land and Building: Lease Classification—Lessee

Transfer of Title or Bargain Purchase Option

If a lease involves land and building, and either of the following criteria are met:

the lessee accounts for the lease as a capital lease.

If the lease is classified as a capital lease, land and building are capitalized separately by the lessee. The present value of the minimum lease payments (after deducting executory costs and any profit thereon) is allocated between land and building in proportion to their fair values at the inception of the lease.⁵⁴ The building is amortized consistent with the lessee's normal depreciation policy for owned assets.⁵⁵

75% of Economic Life Test and 90% of Fair Value Test

If the lease does not transfer title to the real property and does not contain a bargain purchase option, the lessee has to determine the fair value of the land as compared to the fair value of the real estate property leased. If the fair value of the land is less than 25% of the fair value of the leased property, land and building are considered a single unit for purposes of applying criteria 3 and 4 (75% of economic life test; 90% of fair value test).

Fair Value of Land Is Less than 25% of the Fair Value of Leased Property

For a lease of land and building that does not transfer title and does not contain a bargain purchase option, with the fair value of the land being less than 25% of the total fair value of the leased property at the inception of the lease, the following rules apply:

If either criterion 3 (75% of economic life test) or 4 (90% of fair value test) is met, the lessee capitalizes land and building as a single unit and amortizes that unit consistently with the lessee's normal depreciation policy for buildings, except that the period of amortization is the lease term. The leased asset is amortized to its expected value to the lessee at the end of the lease term. For example, if the lessee guarantees a residual value at the end of the lease term and has no interest in any excess that may be realized, the expected value of the leased property to the lessee is the amount that can be realized by the lessee from the leased property at the end of the lease term, up to the amount of the residual value guarantee.⁵⁶

If the lease meets neither the 75% of useful life test nor the 90% of fair value test, land and building are accounted for as a single operating lease.⁵⁷

Fair Value of Land Equals or Exceeds 25% of the Fair Value of Leased Property.⁵⁸

For a lease of land and building that does not transfer title and does not contain a bargain purchase option, land and building are considered separately for purposes of applying the 75% of economic life test and the 90% of fair value test, if the fair value of the land equals or exceeds 25% of the total fair value of the leased property at the inception of the lease. The minimum lease payments (after deducting executory costs including any profit thereon) applicable to the land and the building are separated by determining the fair value of the land and applying the lessee's incremental borrowing rate to it to determine the annual minimum lease payments applicable to the land element. The remaining minimum lease payments are attributed to the building element.

If the building element of the lease meets the 75% of economic life test or the 90% of fair value test, the building element is accounted for as a capital lease and amortized consistently with the lessee's normal depreciation policy, except that the period of amortization is the lease term rather than the useful life of the building. The building is amortized to its expected value to the lessee at the end of the lease term, up to the amount of a residual value guarantee.

The land element of the lease is accounted for separately as an operating lease.

If the building element of the lease meets neither the 75% of economic life test nor the 90% of fair value test, both the building element and the land element are accounted for as a single operating lease.

Exhibit 4.5 illustrates the lease classification for leases involving land and building from the perspective of the lessee.

4.4.2.2 Leases Involving Land and Building: Lease Classification—Lessor

Transfer of Title.⁵⁹

If a lease that involves land and building transfers title at the end of the lease, and the fair value of the leased property at the inception of the lease is greater or less than its carrying amount, the lessor classifies the lease as a sales-type lease. The lessor accounts for the lease like an owner of land and buildings that sells real estate.

If the fair value of the leased property at the inception of the lease equals its carrying amount, the lessor classifies the lease as a direct financing lease or a leveraged lease, if both of the following two criteria are met:

If the lease does not meet both of these criteria, the lessor accounts for the lease as an operating lease.

Bargain Purchase Option.⁶⁰

If a lease that involves land and building contains a bargain purchase option and the fair value of the leased property at the inception of the lease is greater or less than its carrying amount, the lessor classifies the lease as an operating lease. If the fair value of the leased property at the inception of the lease equals its carrying amount, the lessor classifies the lease as a direct financing lease or a leveraged lease⁶¹ if both of the following two criteria are met:

Otherwise, the lessor accounts for the lease as an operating lease.

75% of Economic Life Test and 90% of Fair Value Test

If the lease does not transfer title and does not contain a bargain purchase option, the accounting depends on the proportion of the fair value of the land as compared to the total value of the leased property.

Fair Value of Land is Less than 25% of the Fair Value of Leased Property.⁶²

If the fair value of the land is less than 25% of the total fair value of the leased property at the inception of the lease, and the lease neither transfers title nor contains a bargain purchase option, the lessor considers land and building as a single unit for purposes of applying criteria 3 and 4 (75% of economic life test and 90% of fair value test). For purposes of the 75% of economic life test, the estimated economic life of the building is considered to be the estimated economic life of the unit.

If the fair value of the leased property equals its cost or carrying amount,⁶³ and either criterion 3 or 4 and both of the following criteria are met:

the lessor accounts for the lease as a single unit as a direct financing lease or a leveraged lease. Otherwise, the lease is accounted for as an operating lease.⁶⁴

Fair Value of Land Equals or Exceeds 25% of the Fair Value of Leased Property.⁶⁵

The lessor should consider land and building separately for purposes of applying the 75% of economic life test and the 90% of fair value test⁶⁶ if the fair value of the land equals or exceeds 25% of the total fair value of the leased property at the inception of the lease and the lease does not either transfer title or contain a bargain purchase option.

These rules apply for lease classification: If the building element of the lease with a fair value equal to its cost or carrying amount⁶⁷ meets either the 90% of fair value test or the 75% of economic life test and both of the following criteria:

the building element is accounted for as a direct financing lease or a leveraged lease.

The land element of the lease is accounted for separately as an operating lease.

Otherwise, both the building element and the land element are accounted for as a single operating lease.⁶⁸

4.4.3 Leases Involving Equipment as Well as Real Estate

This section pertains to leases that involve equipment other than integral equipment. Integral equipment subject to a lease is considered real estate. If the cost to remove the equipment plus the decrease in value⁶⁹ is in excess of 10% of the equipment's fair value, equipment is considered “integral equipment.” Section 5.2 of Chapter 5 includes an example related to integral equipment.

If a lease involving real estate includes equipment that does not meet the criteria of integral equipment, the equipment lease is considered a lease separate from the lease of the land and building. Accordingly, the portion of the minimum lease payments applicable to the equipment element of the lease needs to be estimated. Topic 840 (FASB Statement No. 13) does not specify any particular methodology to be used for that allocation.⁷⁰

4.4.4 Leases Involving Part of a Building

When the leased property is part of a larger whole, the carrying amount of the leased portion or its fair value may not be objectively determinable, as, for example, when an office or floor of a building is leased. The accounting for leases involving only part of a building depends on whether the carrying amount and fair value of the leased property are objectively determinable.

4.4.4.1 Leases Involving Part of a Building: Lease Classification—Lessee

Fair Value Objectively Determinable.⁷¹

If the fair value of the leased property is objectively determinable, the lessee classifies and accounts for the lease according to the provisions for leases involving land and building. A question arises of how to determine fair value in situations in which there are no sales of property similar to the leased property. ASC 840-10-25-23 (FASB Interpretation No. 24, paragraphs 5 and 6) provides, in part:

[R]easonable estimates of the leased property's fair value might be objectively determined by referring to an independent appraisal of the leased property or to estimated replacement cost information. Similarly, although replacement cost will not reflect the fair value of the leased property in all circumstances, if the leased facility has been recently constructed or acquired, cost estimates may provide a reasonable basis for estimating the property's fair value for purposes of applying the minimum-lease-payments criterion in paragraph 840-10-25-1(d).

Fair Value Not Objectively Determinable.⁷²

If the fair value of the leased property is not objectively determinable, the lessee accounts for the lease as an operating lease, unless the 75% of economic life test is met, using the estimated economic life of the building in which the leased premises are located. If the 75% of economic life test is met, the leased property is capitalized as a single unit and amortized in a manner consistent with the lessee's normal depreciation policy, except that the period of amortization is the lease term. The asset is amortized to its expected value to the lessee at the end of the lease term.⁷³

Leased Property Owned by Governmental Unit

Because of special provisions normally present in leases involving terminal space and other airport facilities owned by a governmental unit or authority, the economic life of such facilities for purposes of classifying the lease is essentially indeterminate.⁷⁴ Similarly, the concept of fair value is not applicable to leases of terminal space and other airport facilities. Since such leases do not provide for a transfer of ownership or a bargain purchase option, they are classified as operating leases. This “automatic” classification as an operating lease applies only if all of these conditions are met:

Leases of terminal space or other airport facilities that do not meet all of these criteria are classified in accordance with the real estate lease classification criteria in Topic 840 (Statement No. 13).⁷⁵

Leases of other facilities owned by a governmental unit or authority that grant essentially the same rights to the parties as in the lease of airport facilities are also classified as operating leases. Facilities at ports and bus terminals are examples of such leases.⁷⁶

4.4.4.2 Leases Involving Part of a Building: Lease Classification—Lessor

Carrying Amount and Fair Value Determinable.⁷⁷

If the carrying amount and fair value of the leased property are objectively determinable, the lessor classifies and accounts for the lease according to the provisions of leases involving land and building.

Carrying Amount or Fair Value Not Objectively Determinable.⁷⁸

If either the carrying amount or the fair value of the leased property is not objectively determinable, the lessor accounts for the lease as an operating lease.

4.5 Accounting for Leases

4.5.1 Accounting for Leases—Lessee

As previously outlined, from the perspective of the lessee, a lease is classified as either an operating lease or a capital lease.

4.5.1.1 Operating Lease

Topic 840 (Statement No. 13) provides that “rentals” under an operating lease are charged to expense on a straight-line basis over the lease term, unless another systematic and rational basis is more representative of the time pattern the leased property is physically employed.⁷⁹

Section 4.6.5 discusses accounting considerations to be made when leases provide for scheduled rent increases or rent holidays.

4.5.1.2 Capital Lease

The lessee records a capital lease as an asset and a related lease obligation at an amount equal to (1) the present value of minimum lease payments over the lease term or (2) the fair value of the assets, if the fair value of the leased asset is lower than the present value of minimum lease payments.⁸⁰ Each minimum lease payment is allocated between a reduction of the lease obligation and interest expense in a manner that results in a constant periodic rate of interest on the remaining balance of the obligation.⁸¹

Residual Value Guarantees

Some lease agreements include residual value guarantees (i.e., the lessee guarantees a certain value of the leased asset to the lessor at the end of the lease). The minimum lease payments are allocated between a reduction of the obligation and interest expense so that the balance of the lease obligation at the end of the lease term equals the amount of the residual value guarantee.⁸² If the fair value of the asset at the end of the lease term is greater than or equal to the guaranteed residual amount, the lessee incurs no additional obligation. However, if the fair value of the leased asset is less than the guaranteed residual value, the lessee must make up the difference. The guaranteed residual value is often used as a tool to reduce the periodic payments by substituting periodic lease payments with a lump-sum residual value amount.

A residual value guarantee has to be taken into consideration when computing amortization to avoid a gain or loss at the end of the lease term: The leased asset is amortized to the lesser of its guaranteed residual value or expected residual value, unless the lessee benefits, if the fair value of the leased asset at the end of the lease term is greater than the guaranteed residual amount.⁸³ This results in a rational and systematic allocation of amortization expense over the lease term.

4.5.2 Accounting for Leases—Lessor

From the lessor's point of view, a lease can be classified as one of these types:

The lessor accounts for these leases as follows.

4.5.2.1 Operating Lease

The property under lease remains on the lessor's books and is depreciated following the lessor's depreciation policy for that type of property.

Rental payments received are recorded as rental revenues by the lessor on a straight-line basis over the lease term, unless another basis of systematic allocation is more representative of the time pattern over which the lessee has possession of or controls the physical use of the property.⁸⁴ Lessors are prohibited from taking into consideration factors such as the time value of money, anticipated inflation, or expected future revenues.⁸⁵ If any scheduled increase is due to additional property leased, the escalated rents should be considered rental expense or rental revenue attributable to the leased property and recognized in proportion to the additional leased property during the periods that the lessee has control over the use of the additional leased property.⁸⁶ The amount of rental expense or rental revenue attributed to the additional leased property should be proportionate to the relative fair value of the additional property as determined at the inception of the lease, in the applicable time periods during which the lessee controls its use.

Any initial direct costs incurred by the lessor in negotiating and consummating leasing transactions, such as commissions and legal fees, are amortized over the lease term.⁸⁷

A lease agreement may include incentives for the lessee to sign the lease, such as cash payments made to or on behalf of the lessee. Such incentives are considered reductions of rental revenue by the lessor, and recognized straight-line over the term of the lease.⁸⁸

4.5.2.2 Sales-type Leases

A sales-type lease generates two types of revenue for the lessor:

At the beginning of a sales-type lease, the lessor generally records four items on its books:⁸⁹

Exhibit 4.6 illustrates the elements of a sales-type lease.

4.5.2.3 Direct Financing Lease

The accounting for a direct financing lease is similar to the accounting for a sales-type lease. The primary difference is that under a direct financing lease, the lessor records only interest income; no profit is recognized from the sale of the asset.

At the beginning of the lease, the lessor records these three items on its books:

Exhibit 4.7 illustrates the elements of a direct financing lease.

4.6 Special Accounting Issues

4.6.1 Extensions and Renewals of a Lease

Generally, the extension of a lease beyond the expiration of its existing lease term (e.g., through the exercise of a lease renewal option) creates a new agreement, which is classified according to the lease classification criteria outlined in Sections 4.3 and 4.4 and accounted for accordingly.⁹⁵ The accounting rules in Topic 840 (FASB Statement No. 13) related to extensions and renewals of leases are very specific; the accounting depends on a number of factors, including the type of lease and the existence of residual value guarantees. Therefore, when dealing with extensions or renewals, it is advisable to carefully consider the guidance provided by Topic 840 (Statement No. 13). The following sections provide an overview over the rules, without attempting to cover all scenarios.

4.6.1.1 Accounting for Extensions and Renewals of a Lease—Lessee

Existing Lease: Operating Lease; New Lease: Capital Lease

If the original lease is classified as operating lease and the new lease is classified as capital lease, the lessee should record an asset and lease obligation at the present value of the remaining minimum lease payments or the fair value of the leased asset, if lower, pursuant to ASC 840-30-30-1 and 30-3 (paragraph 10 of Statement No. 13).

The change in lease classification is reflected on the books of the lessee at the time of lease extension or renewal. The term of the new lease includes the remaining term of the original lease plus the extension/renewal.

Existing Lease: Capital Lease; New Lease: Operating Lease.⁹⁶

If the original lease is classified as capital lease and the new lease is classified as operating lease, the existing lease continues to be accounted for as a capital lease until the end of its original term, and the renewal or extension is accounted for as an operating lease.⁹⁷ The transaction is accounted for by the lessee in accordance with the guidance for sale-leaseback transactions.⁹⁸

Existing Lease: Capital Lease; New Lease: Capital Lease.⁹⁹

If both the original lease and the new lease meet the lease classification criteria for capital leases, the balances of the leased asset and lease obligation are adjusted by an amount equal to the difference between the present value of the future minimum lease payments under the new agreement and the present balance of the obligation, with no gain or loss being recognized. In computing the present value of the future minimum lease payments under the modified agreement, the rate of interest should be the same rate that was used initially to record the lease obligation.¹⁰⁰

Existing Lease: Operating Lease; New Lease: Operating Lease

If the original lease is classified as an operating lease and the new lease is also classified as an operating lease, the remaining lease payments under the original operating lease and the lease payments over the extension or renewal period are straight-lined over the new lease term. Similarly, deferred rent credits on the lessee's balance sheet are also recognized over the new lease term.

Capital Lease with Residual Value Guarantee or Penalty for Failure to Renew the Lease

In leases containing a residual value guarantee by the lessee or a penalty for failure to renew the lease at the end of the lease term, the balance of the obligation at the end of the lease term equals the amount of the guarantee or penalty at that date. In the event that a renewal of the lease, an extension of the lease term, or a new lease under which the lessee continues to lease the same property renders the guarantee or penalty inoperative, the asset and the obligation under the lease are adjusted by an amount equal to the difference between the present value of the future minimum lease payments under the revised agreement and the present balance of the obligation. The present value of the future minimum lease payments under the revised agreement is computed using the rate of interest used to record the lease initially.¹⁰¹

4.6.1.2 Accounting for Extensions and Renewals of a Lease—Lessor

Existing Lease: Operating Lease; New Lease: Sales-type Lease or Direct Financing Lease

If, in a lease involving real estate, the original lease is classified as an operating lease and the new lease is classified as a sales-type lease,¹⁰² the lessor has to consider the provisions in Subtopic 360-20 (FASB Statement No. 66)¹⁰³ in determining whether it is appropriate to remove the property from the books and recognize profit on the transaction. As the carrying amount of the leased asset at the time of extension or renewal of an operating lease generally does not equal its fair value, a change from operating lease classification to direct finance lease classification rarely ever occurs.¹⁰⁴

Existing Lease: Sales-type or Direct Financing Lease; New Lease: Operating Lease.¹⁰⁵

If the original lease is classified as a sales-type lease or a direct financing lease, and the new lease is classified as an operating lease, the existing lease continues to be accounted for as a sales-type lease or direct financing lease under the existing agreement until the end of its original term, and the renewal or extension is accounted for as an operating lease.¹⁰⁶

Existing Lease: Sales-type or Direct Financing Lease; New Lease: Sales-type Lease

If a renewal or extension of an original sales-type or direct financing lease that occurs at or near the end¹⁰⁷ of the lease term of the existing lease meets the criteria for a sales-type lease, the renewal or extension is accounted for as a sales-type lease;¹⁰⁸ a renewal or extension of a sales-type lease or a direct financing lease that does not occur at or near the end of the existing lease term, but ordinarily would meet the criteria of a sales-type lease, is accounted for as a direct financing lease. ASC 840-10-25-51 (paragraph 6(b)(i) of Statement No. 13) provides: “A renewal or an extension of an existing sales-type or direct financing lease (including a new lease under which the lessee continues to use the same property) that otherwise qualifies as a sales-type lease shall be classified by the lessor as a direct financing lease unless the renewal or extension occurs at or near the end of the original term specified in the existing lease, in which circumstance it shall be classified as a sales-type lease.”

Existing Lease: Sales-type or Direct Financing Lease; New Lease: Direct Financing Lease

If the original lease is classified as a sales-type lease or direct financing lease, and the new lease is classified as a direct financing lease,¹⁰⁹ the balance of the minimum lease payments receivable and the estimated residual value are adjusted based on the provisions of the new lease, and the net adjustment is charged or credited to unearned income,¹¹⁰ subject to these restrictions:

Existing Lease: Operating Lease; New Lease: Operating Lease

If the original lease is classified as an operating lease and the new lease is also classified as an operating lease, the remaining lease payments under the original operating lease and the lease payments over the extension or renewal period are straight-lined over the revised lease period.

Sales-type Leases and Direct Financing Leases with Residual Value Guarantee or Penalty for Failure to Renew the Lease

In leases containing a residual guarantee by the lessee or a penalty for failure to renew the lease at the end of the lease term, the balance of the obligation at the end of the lease term equals the amount of the guarantee or penalty at that date. In the event that a renewal of the lease, an extension of the lease term, or a new lease under which the lessee continues to lease the same property renders the guarantee or penalty inoperative, the asset and the obligation under the lease are adjusted for the changes resulting from the revised agreement,¹¹³ and the net adjustment is charged or credited to unearned income.¹¹⁴

4.6.2 Modifications to the Provisions of a Lease

A change in the provisions of the lease, other than the renewal or extension of an existing lease, may or may not be considered a new agreement. Such modifications may result from adjusting contingent rentals, shortening the lease term, or adjusting minimum lease payments, for example. Generally, if modifications to the provisions of a lease are made in connection with the extension of the lease term, the rules for extensions and renewals are applicable.¹¹⁵

To evaluate whether a modification to the provisions of a lease other than a lease extension or renewal is considered a new agreement, a determination needs to be made whether the provisions of the revised lease would have resulted in a different lease classification had these terms been in effect at the inception of the lease.¹¹⁶ If the provisions of the revised lease would not have resulted in a different lease classification had these terms been in effect at the inception of the lease, no new lease agreement has been created, and any adjustments to the existing lease agreement are accounted for prospectively. However, if the provisions of the revised lease would have resulted in a different lease classification had the changed terms been in effect at the inception of the lease, the lease classification and corresponding accounting is determined using current assumptions as of the date of modification, for example, with respect to the fair value of the leased asset, the residual value, and the implicit and incremental borrowing rates.

4.6.2.1 Accounting for Lease Modifications—Lessee

Capital Lease Remains Capital Lease

If the original lease is a capital lease and the modification of the lease terms either:

then the balances of the asset and the lease obligation are adjusted by an amount equal to the difference between the present value of the future minimum lease payments under the modified agreement and the current balance of the lease obligation, with no resulting gain or loss being recognized. The present value of the future minimum lease payments under the modified agreement is computed using the same rate of interest as the rate that was used initially to record the lease obligation.¹¹⁸

Existing Lease: Capital Lease; New Lease: Operating Lease

If the existing lease is a capital lease and the new agreement is classified as an operating lease, the transaction is accounted for as a sale-leaseback transaction and is accounted for in accordance with the sale-leaseback guidance.¹¹⁹

Existing Lease: Operating Lease; New Lease: Capital Lease

If the existing lease is an operating lease and the new agreement is classified as a capital lease, the asset and lease obligation are recorded—at the date of lease modification—at the present value of the remaining minimum lease payments or the fair value of the leased asset, if lower.¹²⁰

Operating Lease Remains Operating Lease

Changes in lease provisions of an operating lease that do not result in a different lease classification are rent adjustments that are accounted for prospectively.¹²¹

4.6.2.2 Accounting for Lease Modifications—Lessor

Sales-type or Direct Financing Lease Remains Sales-type or Direct Financing Lease

If an existing lease is classified as a sales-type or direct financing lease, and the lease under the revised terms also results in the classification of a sales-type or direct financing lease, the lessor accounts for the change in the provisions of the lease in the following manner: The balances of the minimum lease payments receivable and the estimated residual value are adjusted, and the net adjustment is charged or credited to unearned income¹²² subject to certain restrictions:

Existing Lease: Sales-type or Direct Financing Lease; New Lease: Operating Lease

If the existing lease is a sales-type lease or direct financing lease and the new lease is classified as an operating lease, the remaining net investment is removed from the lessor's books. The leased asset is recorded at the lower of its original cost, fair value, or carrying amount; the net adjustment is charged to income of the period.¹²⁵

Existing Lease: Operating Lease; New Lease: Sales-type or Direct Financing Lease

If the existing lease is classified as an operating lease at the inception of the lease, and the new lease is classified as a sales-type lease,¹²⁶ the new lease is reflected on the books of the lessor at the date of the lease modification as a sales-type lease following the accounting described in Section 4.5.2. As the carrying amount of the leased asset at the time of modification of an operating lease generally does not equal its fair value, a change from operating lease classification to direct finance lease classification rarely occurs.¹²⁷

4.6.3 Lease Termination

4.6.3.1 Lease Termination—Capital Lease

At the termination of a capital lease, the asset and related obligation are removed from the books and a gain or loss is recognized for any difference.¹²⁸

4.6.3.2 Lease Termination—Sales-type Lease and Direct Financing Lease

A termination of a sales-type lease or direct financing lease is accounted for by removing the net investment from the lessor's books; recording the asset at the lower of its original cost, fair value, or present carrying amount; and charging the net adjustment to income of the period.¹²⁹

4.6.3.3 Determining whether a Lease Modification Is a Lease Termination

A modification of a lease may, in substance, be a lease termination. In some circumstances, a change in terms may be a combination of a lease termination and a lease modification, such as a lessee vacating part of the office space leased and modifying the terms of the remaining space rented.

The Emerging Issues Task Force¹³⁰ addressed this issue: An entity leases an asset under an operating lease for use in its operations. Prior to the expiration of the original lease term, lessee and lessor agree to modify the lease by shortening the lease term and increasing the lease payments over the shortened lease period. The modification does not change the lease classification, and no other changes are made to the lease.

The Task Force concluded that the appropriate accounting treatment for the increase in the lease payments over the shortened lease period depends on the relevant facts and circumstances and is a matter of judgment. If the increase is, in substance, only a modification of future lease payments, the increase is accounted for prospectively over the term of the modified lease. If the increase is, in substance, a termination penalty, it is charged to income in the period of the lease modification.

4.6.3.4 Treatment of Costs Incurred when Terminating an Operating Lease

Subtopic 420-10 (FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities) provides guidance for the treatment of costs associated with exit or disposal activities, which includes costs to terminate an operating lease.¹³¹

Costs to terminate an operating lease or other contract include both:

Costs to Terminate the Contract before the End of Its Term

A liability for costs to terminate an operating lease contract before the end of its term is recognized and measured at its fair value in the period in which the liability is incurred, assuming its fair value can be reasonably estimated.¹³² Subtopic 420-10 (Statement No. 146) clarifies that only present obligations to others are considered “liabilities” for this purpose;¹³³ an obligation to others may be created, for example, when a lessee gives written notice of the termination of a lease to the lessor. If the fair value cannot be reasonably estimated in the period in which the liability is incurred, which is expected to be unusual, the liability is recognized in the period in which fair value can be reasonably estimated.¹³⁴

Any subsequent change in the amount of the liability arising from a revision in the amount or the timing of estimated cash flows is recognized as an adjustment to the liability in the period of change. The fair value of such change is measured using the credit-adjusted risk-free rate initially used to measure the liability. Changes due to the passage of time are recognized as an increase in the carrying amount of the liability and as (accretion) expense. Accretion expense is not considered interest cost for purposes of applying Subtopic 835-20, Capitalization of Interest (FASB Statement No. 34, Capitalization of Interest Cost) or for purposes of income statement classification.¹³⁵

Costs Incurred over the Remaining Lease Term

A liability for costs that continue to be incurred under a lease contract for its remaining term without economic benefit to the entity is recognized and measured at its fair value when the entity ceases using the leased property (referred to as cease-use date).

For an operating lease contract, the fair value of the liability at the cease-use date is determined based on the remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for the property, even if the entity does not intend to enter into a sublease. Remaining lease rentals are not reduced to an amount less than zero.¹³⁶

Any subsequent change in the amount of the liability arising from the revision of the amount or the timing of estimated cash flows is recognized as an adjustment to the liability in the period of change. The fair value of such change is measured using the interest rate that was used to measure the liability initially. Changes due to the passage of time are recognized as an increase in the carrying amount of the liability and as an (accretion) expense. Accretion expense is not considered interest cost for purposes of applying Subtopic 835-20 (Statement No. 34) or for purposes of income statement classification.¹³⁷

4.6.4 Purchase and Sale of Leased Asset before the End of the Lease Term

4.6.4.1 Purchase of Leased Asset

Asset Leased under Capital Lease

The termination of a capital lease¹⁴¹ that results from the purchase of a leased asset by the lessee is not the type of transaction contemplated by the provisions related to lease termination, but rather should be considered an integral part of the purchase of the leased asset. ASC 840-30-35-14 (paragraph 5 of FASB Interpretation (FIN) No. 26, Accounting for Purchase of a Leased Asset by the Lessee during the Term of the Lease) states, in part:

If the lessee purchases property leased under a capital lease, any difference between the purchase price and the carrying amount of the capital lease obligation shall be recorded by the lessee as an adjustment of the carrying amount of the asset.

The purchased asset under lease needs to be evaluated for impairment following the provisions in Subtopic 360-10 (FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets). If the carrying amount of the asset is less than the undiscounted cash flows, but exceeds the purchased asset's fair value, loss recognition, while not required by Subtopic 840-30 (FASB Statement No. 13 or FIN 26) is not precluded.¹⁴²

Asset Leased under Operating Lease

The accounting for a purchase of an asset leased under an operating lease is not addressed in the authoritative guidance; rather, the accounting for the purchase of an asset leased under capital lease is generally applied by analogy. If a leased asset classified as operating lease is purchased before the end of the lease term, any deferred credits resulting from straight-line recognition of rentals will be recorded as an adjustment to the cost of the purchased asset rather than recognized as income at the time of purchase.

4.6.4.2 Sale of Leased Asset

Asset Leased under Operating Lease

The lessor accounts for the sale of an asset leased under an operating lease as a sale and recognizes profit. If the asset under lease is a real estate asset, the seller has to take into consideration the provisions of Subtopic 360-20 (FASB Statement No. 66), which may preclude sale or profit recognition of the transaction at the time of the transaction.¹⁴³ Any deferred costs or deferred rent resulting from straight-line recognition of rentals are included in the determination of profit on the sale.

Asset Leased under Sales-Type or Direct Financing Lease

If a lessor sells a leased asset accounted for as a sales-type or direct financing lease, the assets and liabilities on the books of the lessor that relate to the leased asset are removed from the books and charged or credited to income.

4.6.5 Rent Holiday and Scheduled Rent Increases/Decreases

Lease agreements may specify scheduled rent increases/decreases, or they may include a payment schedule specifying the timing of rental payments over the lease term. Such agreements may have been designed to reflect the anticipated effects of inflation and time value of money, to take into consideration any specific cash flow situation of the lessee, or to provide an inducement or “rent holiday” to the lessee.

Operating Leases

Rental payments are recognized on a straight-line basis over the lease term unless another systematic and rational basis is a better representation of the time pattern in which the leased property is physically employed.¹⁴⁴ The determination of what constitutes the “leased asset” is critical in determining the lease commencement date, which marks the beginning of the lease term. Take a lessee that leases retail space in a shopping mall, for example. If the lessee leases an “empty shell,” which it intends to build out and use as retail space, that lease will commence at the date the lessee takes possession and obtains control over the leased space, regardless of whether the lease agreement allows for a rent-free period at the beginning of the lease. If the lessee were to lease the space built-out to its specifications, however (i.e., the lessor is responsible for building out the space), the lease would commence at the time the build-out is complete.

If the lessee leases an “empty shell,” recognition of rental expense or rental revenue should commence at the date the lessee takes possession of or controls the physical use of the leased space, even if the lessee does not have to make any lease payments until store-opening. Since rentals under an operating lease are recognized straight line over the term of the lease, the lessee would record rental expense and a corresponding liability, and the lessor would record a receivable and corresponding rental revenue over this rent-free time period.

Leases Other than Operating Leases

In leases accounted for as capital leases (lessee) or sales-type/direct financing leases (lessor), interest expense/revenue is recorded using the effective interest method over the lease term. The considerations discussed earlier under operating leases related to the questions “What is the property under lease?” and “When does the lease term commence?” apply equally to leases that are not operating leases.

Time Pattern of the Physical Use of the Property

The FASB considers the right to control the physical use of the leased property the equivalent to physical use.¹⁴⁵ When the lessee controls the use of the leased property, recognition of rental expense or rental revenue should not be affected by the extent to which the lessee contemplates utilizing that property; for operating leases, the rental payments are recognized as rental expense or rental revenue on a straight-line basis.¹⁴⁶ However, if scheduled rent increases are due to the lessee gaining access to and control over additional leased property over the lease term, such increases in rentals attributable to additional leased property are recognized straight line over the portion of the lease term in which the lessee has control over the use of the additional leased property. The amount of rental expense or rental revenue attributed to the additional leased property is based on the relative fair value of the additional property leased and the period during which the lessee has the right to control the use of the additional property.¹⁴⁷

4.6.6 Contingent Rentals

Lease agreements may include a base rental and a contingent rental amount. Contingent rentals are rental amounts that depend on factors occurring subsequent to the inception of the lease, except for increases of minimum lease payments related to increases in the cost of leased property or similar fact patterns.¹⁴⁸ Contingent rentals contemplate an uncertainty about future changes in the factors on which lease payments are based.

For example, rent for retail space often consists of two parts: a fixed or base amount per square foot and additional rent if certain targets are met. Such targets may be linked to the lessee achieving a certain level of operating income, revenue, or another measure agreed upon between lessor and lessee. Similarly, lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety.

A probability-based approach to determine whether rentals should be considered minimum lease payments or contingent rentals was rejected by the FASB because of the subjectivity involved in that approach.¹⁴⁹ Nevertheless, the substance of the transaction should be considered when determining whether “contingent” rental payments are in substance disguised minimum lease payments. Some lease agreements may provide for rentals that are seemingly contingent, although in reality they are virtually assured. For example, the lease may provide for an increase in lease payments based on the lesser of 3% or 5 times the change in the consumer price index (CPI). The Securities and Exchange Commission (SEC) staff has taken the view that if such rent increase is virtually certain (3% in the example), that contingent rent should be included in minimum lease payments, rather than treated as contingent rentals.

If a leverage factor is used, such as rentals that increase by two times the change in the CPI, the lease agreement may contain an embedded derivative that must be bifurcated pursuant to the provisions of Topic 815, Derivatives and Hedging (FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities).

Contingent Rent Based on Index

Lease payments that are related to an existing index or rate, such as the CPI or the prime interest rate, are included in minimum lease payments based on the index or rate existing at the inception of the lease; any increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals. If the increase or decrease in lease payments is based on a change in the index or rate, however, rather than the index or rate itself, such increase or decrease is considered contingent rent.¹⁵⁰

Accounting by the Lessee

A lessee should recognize contingent rental expense in accordance with the criteria for recognizing a liability:¹⁵¹, ¹⁵² A liability is recorded prior to the achievement of the specified target that triggers the contingent rental expense, if the achievement of that target is considered probable and if the amount can be reasonably estimated. ASC 450-20-25-2 (paragraph 8 of FASB Statement No. 5) provides, in part:

An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

Contingent rental expense recorded in prior periods is reversed into income at the time it becomes probable that the specified target will not be met.¹⁵³

Accounting by the Lessor

A lessor should defer the recognition of contingent rental income until the specified target that triggers the contingent rental income is achieved. Prior to the lessee's achievement of the target on which contingent rentals are based, the lessor has no legal claims on the contingent amounts.¹⁵⁵

4.6.7 Lease Incentives in Operating Leases

An operating lease agreement may include incentives for the lessee to sign the lease, such as: an up-front cash payment to the lessee; payment of costs on behalf of the lessee, such as moving expenses; or the assumption by the lessor of the lessee's preexisting lease with a third party. Payments made to or on behalf of the lessee represent lease incentives that should be considered reductions of rental expense by the lessee and reductions of rental revenue by the lessor over the term of the new lease. Similarly, losses incurred by the lessor as a result of assuming a lessee's preexisting lease with a third party should be considered an incentive by both the lessor and the lessee. Incentives are recognized on a straight-line basis over the term of the new lease.¹⁵⁶

Lease Incentives versus Leasehold Improvements

A lessor may provide the tenant with leasehold improvements (tenant improvements), such as fixtures or new carpets in the leased space. The lessor may install such leasehold improvements for the tenant or provide the tenant with an allowance to build out the leased space. Lessor funding of leasehold improvements may be direct or indirect—cash paid directly to the lessee or cash paid to third parties on behalf of the lessee.

Leasehold Improvements—Accounting by the Lessee.

The accounting for lease incentives led to numerous restatements on the books of lessees in early 2005, triggered—in part—by a letter from Donald T. Nicolaisen, then Chief Accountant of the SEC, in which he clarified his views regarding the accounting for lease incentives from the perspective of the lessee:¹⁵⁹

Leasehold Improvements—Accounting by the Lessor.

Lessors also face the question as to how to account for lessor funding of leasehold improvements: Should funds provided to a tenant that are intended for the construction of leasehold improvements be recorded as leasehold improvements (i.e., property, plant, and equipment) or lease incentives? The determination of whether amounts payable under a lease are lease incentives or leasehold improvements depends on the property under lease (e.g, empty shell versus built-out space) and the contractual rights of lessee and lessor.

An agreement may specify that the allowance is intended to be used by the tenant to fund leasehold improvements; however, if the agreement does not require that the tenant provide the landlord with proof of spending for tenant improvements or otherwise provide for a mechanism under which the landlord can monitor the usage of the tenant allowance, the payment to the tenant may be more akin to a lease incentive than the acquisition of property, plant, and equipment. Similarly, an agreement that allows the tenant to retain any funds not used for the construction of leasehold improvements indicates that the payment by the lessor is in substance a lease incentive.

The classification of such lessor funding of leasehold improvements as incentives versus property, plant, and equipment has a major impact on lessors of real estate, such as real estate investment trusts (REITs), that use funds from operations (FFO) as a performance measure: Real estate-related depreciation is added back to net income to arrive at FFO, whereas the amortization of incentives provided to tenants is not added back. Therefore, a lessor's classification of payments as leasehold improvements rather than lease incentives results in higher FFO and may lead to a perception of higher performance by investors.

4.6.8 Subleases and Lease Substitutions

Subleases and lease substitutions include three types of arrangements:

The substitution of a leased asset for a different asset is accounted for as the termination of the existing lease and the entering into a new lease.

4.6.8.1 Accounting by the Original Lessor

If the original lessee enters into a sublease (Arrangement Type 1) or if the original lease agreement is transferred by the original lessee to a third party (Arrangement Type 2), the original lessor continues to account for the lease as before.¹⁶⁰

If the original lease agreement is replaced by a new agreement with a new lessee (Arrangement Type 3), the lessor accounts for the replacement of the lease as a termination of the original lease. The new lease is classified and accounted for as a separate transaction.¹⁶¹

4.6.8.2 Accounting by the Original Lessee

The original lessee's accounting for the sublease or lease substitution depends on the obligations retained by the lessee:

Original Lessee Relieved of Primary Obligation

The original lessee is relieved of the primary obligation under the original lease if a new lessee is substituted under the original lease agreement and the new lessee becomes the primary obligor (the original lessee may remain secondarily liable) (Arrangement Type 2) or if a new lease agreement is substituted for the original agreement and the original lease is cancelled (Arrangement Type 3). The lessee accounts for such “termination” of the original lease agreement as follows:

Original Lease Is Capital Lease.¹⁶²

The lessee removes the asset and related lease obligation from its books and recognizes a gain or loss for the difference. Any consideration paid or received by the lessee is included in the determination of gain or loss on the substitution or cancellation. For a real estate lease, the provisions of Subtopic 360-20 (FASB Statement No. 66) related to sale and profit recognition must be followed when determining whether the real estate asset and related lease obligation should be removed from the lessee's books and what profit recognition method should be used. Any loss arising from the transaction would be recognized immediately.

If the asset and related lease obligation are removed from the lessee's books, but the lessee remains secondarily liable, the lessee will record a guarantee obligation in accordance with ASC 405-20-40-2 (paragraph 114 of FASB Statement No. 140). That guarantee obligation is initially measured at fair value and reduces the gain or increases the loss on the transaction.

Original Lease Is Operating Lease.¹⁶³

The lessee removes any deferred amounts (e.g., lease incentives, amounts relating to the straight-lining of rent) from its books and recognizes a gain or loss.

A guarantee obligation is recognized by the original lessee in accordance with ASC 405-20-40-2 (paragraph 114 of Statement No. 140) if the lessee remains secondarily liable. That guarantee obligation is initially measured at fair value and reduces the gain or increases the loss on the transaction.

Original Lessee Not Relieved of Primary Obligation

The original lessee is not relieved of its primary obligation if the lessee enters into a sublease (Arrangement Type 1). In that case, the accounting for the original lease contract by the original lessee does not change as a result of the lessee entering into the sublease.

Accounting consequences for the original lessee in its role as sublessor are:

Original Lease Is Capital Lease

If the original lease contains a bargain purchase option or transfers ownership by the end of the lease term, the original lessee (as sublessor) classifies the new lease with the sublessee based on the lease classification criteria of Subtopic 840-10 (Statement No. 13) for lessors.¹⁶⁴

If the original lease agreement does not transfer ownership and does not contain a bargain purchase option, the new lease (sublease) is classified as an operating lease except in these two situations:¹⁶⁵

Original Lease Is Operating Lease

If the original lease meets the criteria of an operating lease, the original lessee accounts for both the original lease and the new lease as operating leases.¹⁶⁶

4.6.8.3 Accounting by the New Lessee

A new lessee under a sublease or similar transaction classifies and accounts for the lease as an operating or capital lease in accordance with the lease classification criteria in Topic 840 (Statement No. 13).¹⁶⁷

4.6.9 Leases and Leasehold Improvements Acquired in a Business Combination

Acquisition of Leases

In a business combination, the purchase price is assigned to the assets acquired and liabilities assumed based on their fair values. Accordingly, lease agreements need to be evaluated as to whether they represent assets or liabilities. Leases may represent assets to the acquirer even if lease terms are at market, because the acquirer does not have to incur the time and expense involved in securing a lease. This can have a significant impact, such as in the acquisition of rental properties, as outlined in Section 1.6.3 of Chapter 1.

Topic 840 (Statement No. 13)¹⁶⁸ requires that the classification of a lease be determined at the inception of the lease. Once that determination has been made, the classification of the lease is not reexamined unless one of these two conditions is present:

In a business combination, the acquiring company retains the classification of the leases it acquires, unless the provisions of the leases are modified in a way that results in the revised agreements being considered new agreements under ASC 840-10-35-4 (paragraph 9 of Statement No. 13). Such “new agreements” are classified according to the lease classification criteria, based on the conditions as of the date of the modification of the leases.¹⁶⁹

Considerations Related to Operating Leases.

Deferred assets or liabilities on the books of the seller arising from the straight-lining of rent or the amortization of initial direct costs are not carried over to the acquirer, since they do not represent assets or liabilities. Deferred revenues of an acquired entity are recognized only in certain instances, such as in the acquisition of a building with in-place leases that were prepaid. The acquirer would recognize the fair value of its obligation to lease space to the tenant that prepaid the rent and, at the same time, recognize an intangible asset relating to the lease.¹⁷⁰

Considerations Related to Capital Leases.

When determining the fair value of a capital lease asset in a business combination, the value assigned to a capital lease asset should reflect the fair value of the right to use the asset rather than the fair value of the asset itself. The fair value of the right to use the asset depends on the terms of the lease. While the fair value of the right-to-use asset and the fair value of the asset under lease may be the same in situations in which title transfers or the lessee has a bargain purchase option, in many arrangements, the fair value of the capital lease asset will be lower than the fair value of the asset. For example, an acquiree may have leased a warehouse, classified as capital lease because the lease term exceeded 75% of the asset's useful life at lease inception. If the remaining lease term were five years at the time of the business combination, the fair value to be recorded by the acquirer would be the fair value of the right to lease that warehouse for a period of five years.

The fair value of the right-to-use asset should be determined independently from the fair value of the related lease obligation; in many instances, the asset and related lease obligation will not be recorded at the same amounts.

Acquisition of Leveraged Leases.

The acquisition of leveraged leases requires special accounting considerations due to the unique accounting, reporting, and disclosure requirements for leveraged leases. ASC 840-30-55-50 through 55-60 (Appendix A of FIN 21) illustrates the accounting for a leveraged lease in a business combination.

Acquisition of Leasehold Improvements

The EITF addressed the issue of how to determine the amortization period for leasehold improvements acquired in a business combination or placed in service significantly after and not contemplated at or near the beginning of the lease term.¹⁷¹ The EITF reached a consensus that leasehold improvements acquired in a business combination should be amortized over the shorter of their useful lives or a term that includes required lease periods and renewals that are deemed to be reasonably assured at the date of acquisition. That guidance does not apply to any other preexisting leasehold improvements.

4.6.10 Impairment of Assets under Lease and Losses on Leasing Activities

4.6.10.1 Impairment of Assets under Lease

The impairment of long-lived assets accounted for as capital leases (by lessees) or operating leases (by lessors) is within the scope of the Impairment or Disposal of Long-Lived Assets subsections of Topic 360 (FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets).¹⁷²

For purposes of recognition and measurement of an impairment loss, a long-lived asset first needs to be grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.¹⁷³ A long-lived asset (asset group) to be held and used, such as real estate property under lease, is considered impaired when the carrying amount of the long-lived asset (asset group) exceeds its fair value. The impairment guidance for long-lived assets prescribes a two-step impairment test.¹⁷⁴ Step 1 is performed to evaluate whether the carrying amount of a long-lived asset (asset group) to be held and used is recoverable. If Step 1 is not met, Step 2 is performed to determine the amount of any impairment loss that needs to be recognized.

The Impairment or Disposal of Long-Lived Assets subsections of Topic 360 (Statement No. 144) provide examples of events and changes in circumstances that require a recoverability test, outlined in Section 3.7.1.1 of Chapter 3.

4.6.10.2 Losses Incurred by Lessee Arising from Operating Leases

Lessees leasing assets under operating leases may incur losses under a lease contract if they discontinue the use of the leased asset and terminate the lease contract. Topic 420, Exit or Disposal Cost Obligations (FASB Statement No. 146), provides guidance with respect to costs associated with such exit or disposal activity.¹⁷⁶ Costs to terminate a lease contract may either be costs to terminate the contract before the end of its term or costs that will continue to be incurred under the contract for its remaining term without economic benefit to the entity.¹⁷⁷ The accounting treatment of such costs is discussed in Section 4.6.3.4 of this chapter.

4.6.10.3 Losses on Subleasing Activities¹⁷⁸

Losses resulting from subleasing property may arise in situations in which a lessee subleases leased property for amounts that are less than the rental payments the lessee is required to make under the lease. If costs expected to be incurred under an operating sublease exceed anticipated revenue from the operating sublease, the lessee needs to record a loss for the excess; such loss should not be deferred and amortized over the lease term. Similarly, if the sublease qualifies as a direct financing lease, the lessee would record as loss the excess of the carrying amount of the investment in the sublease over the total of rentals, estimated residual value, and tax benefits from the sublease transaction.

A lessor may “absorb” losses incurred by a lessee in a sublease to induce the lessee to enter into a new lease with the lessor. This assumption of the lessee's losses under the sublease by the lessor is considered a lease incentive: The lessee would record a loss on the sublease and recognize the incentive as reduction of rent expense over the term of the lease.¹⁷⁹ Similarly, the lessor would record a lease incentive, which is recognized over the term of the lease as a reduction of rental revenue.

4.6.11 Build-to-Suit Leases

In a build-to-suit lease, a lessee is involved in constructing the asset it will lease, once constructed. Build-to-suit leases are commonly encountered in the lease of new headquarters buildings, distribution facilities, data centers, and retail locations. Build-to-suit lease transactions are often structured as synthetic leases. A synthetic lease is a hybrid financing arrangement: For financial reporting purposes, the lessee accounts for a synthetic lease as an operating lease, whereas for income tax purposes, the lessee is deemed the owner of the leased property.

Lessee Involvement in a Build-to-Suit Lease Transaction

In some build-to-suit transactions, a lessee's involvement in the construction of the asset is minimal; for example, the lessee's involvement may be limited to approving engineering drawings for the construction project. In other cases, the lessee may serve as construction agent, general contractor, or developer of the project. Depending on the lessee's involvement during the asset's construction, the lessee may be deemed the owner of the property during the construction period. If that is the case, the lessee has to record the property on its books during the construction phase (e.g., construction in progress). After the construction of the property is complete, it has to be determined whether the lessee can derecognize the property following sale-leaseback guidance. In a sale-leaseback transaction involving real estate, any continuing involvement by the seller-lessee with the leased property—other than a “normal leaseback”—that results in the seller-lessee not transferring the risks or rewards of ownership precludes the derecognition of the real estate property.¹⁸⁰ Since in real estate build-to-suit transactions, such prohibited continuing involvement is often present in the form of purchase options, financing provided to the owner-lessor, and guarantees and indemnities, the asset under lease often remains on the books of the lessee subsequent to construction completion.

The guidance is rule-driven and has been interpreted very strictly. This section provides a brief overview of the major concepts of the guidance related to build-to-suit transactions rather than a complete listing of the specific provisions.¹⁸¹

As a general rule, the lessee is considered the owner of the asset, if the lessee bears substantially all of the construction period risks. ASC 840-40-55-2 (EITF Issue No. 97-10) provides that “[a]n evaluation of whether the lessee has substantially all of the construction period risks should be based on a maximum guarantee test that is similar to the 90 percent recovery test in the minimum lease criterion.” Under that maximum guarantee test, a lessee is considered to have substantially all of the construction period risks if the lessee could be required, under any circumstance, to pay 90% or more of the project costs, excluding land acquisition costs, as of any time before construction is completed. ASC 840-40-55-11 (EITF Issue No. 97-10) provides, in part:

[T]hat assessment should test whether, at each point during the construction period, the sum of the following amounts is less than 90% of the total project costs incurred to date (excluding land acquisition costs, if any):

If that test is not met, the lessee is considered the owner of the real estate project during construction.

For the purpose of making this assessment, amounts the lessee can be required to pay include not only payments for construction costs incurred but all payments that the lessee is obligated to make or can be required to make in connection with the construction project, including, for example, obligations that could arise from being the developer or general contractor, lease payments that must be made regardless of whether the project is complete, payments for indemnities or guarantees, and an obligation to fund construction cost overruns. The likelihood of the lessee actually having to make these payments is not considered when performing that assessment.

In addition to the maximum guarantee test, a number of other factors have to be considered when determining whether the lessee is deemed the owner during the construction period. These factors can be categorized into:

Costs Incurred prior to Lease Inception

ASC 840-40-55-42 through 55-45 (EITF Issue No. 96–21) discuss the nature of costs that may be incurred by a lessee prior to lease inception. To maintain off-balance sheet treatment for a build-to-suit-lease, a lessee may not commence construction activities. Construction activities have commenced if the lessee has broken ground; if the lessee has incurred any “hard costs,” such as site preparation and construction costs; or if it has incurred “soft costs,” such as architectural fees, survey costs, and zoning fees, of more than 10% of the expected fair value of the leased property. If a lessee transfers an option to acquire real estate that it owns to the lessor, the fair value of the option is included in “soft costs.”

Activities during the Construction Period

A lessee should capitalize the leased asset under construction if, in connection with the project:

Indemnification Provisions.¹⁸⁶

The nature of indemnities related to construction completion that a lessee can provide is limited. Except for indemnities related to preexisting environmental risks for which the risk of loss is remote, the lessee is not permitted to provide indemnities or guarantees to any party other than the owner-lessor. Additionally, the indemnifications or guarantees provided to the owner-lessor must be limited to damage claims caused by or resulting from the lessee's own actions or failures to act while in possession or control of the construction project.¹⁸⁷

ASC 840-40-55-16 (EITF Issue No. 97-10) provides an analysis of indemnification/guarantee provisions, which is reproduced in Exhibit 4.8.

4.6.12 Leases between Related Parties

The classification and accounting of leases between related parties is the same as for leases between unrelated parties, except in cases in which it is clear that the terms of the transaction have been significantly affected by the fact that lessee and lessor are related. In such cases, classification and/or accounting are modified to recognize the economic substance of the lease transaction rather than its legal form. Topic 840 (FASB Statement No. 13) requires disclosures related to the nature and extent of leasing transactions with related parties.¹⁸⁸

In consolidated financial statements or in financial statements for which an interest in an investee is accounted for under the equity method of accounting, any profit or loss on a leasing transaction with the related party is accounted for in accordance with the principles for consolidation or equity method of accounting.¹⁸⁹

Capital Leases between Parties under Common Control

Capital lease transactions between entities under common control are accounted for analogous to transfers of assets between companies under common control, as described in ASC 805-50-25-2 (paragraph D9 of FASB Statement No. 141(R)), which states:

When accounting for a transfer of assets or exchange of shares between entities under common control, the entity that receives the net assets or the equity interests shall initially recognize the assets and liabilities transferred [at their carrying amounts in the accounts of the transferring entity] at the date of transfer.

For an asset transferred that is accounted for as an asset under capital lease, the lessee should record the asset based on the lessor's carrying amount. A capital lease obligation is recorded in the amount of the present value of minimum lease payments. Any difference between the carrying amount of the asset and the present value of minimum lease payments is treated as a contribution or distribution of capital.

4.7 Financial Statement Presentation and Disclosure

4.7.1 Presentation and Disclosure—Lessee

ASC 840-10-50-2 (paragraph 16(d) of FASB Statement No. 13) requires a general description of a lessee's leasing arrangements, including:

Disclosures Required for Capital Leases

For assets recorded under capital leases, the accumulated amortization and any related lease obligations need to be separately identified in the lessee's balance sheet or in the footnotes. Also, separate presentation or disclosure of amortization expense relating to assets under capital leases is required, unless the amortization of leased assets is included in depreciation expense of the lessee's fixed assets and that fact is disclosed.¹⁹⁰

Additionally, ASC 840-30-50-1 (paragraph 16(a) of Statement No. 13) requires these disclosures:

Disclosures Required for Operating Leases.¹⁹¹

For all operating leases, lessees need to disclose rental expense for each period for which an income statement is presented, with separate amounts for minimum rentals, contingent rentals, and sublease rentals. Rental payments under leases with terms of one month or less that were not renewed need not be included.

For operating leases that have initial or remaining noncancelable lease terms in excess of one year, two additional disclosures are required:

4.7.2 Presentation and Disclosure—Lessor

When leasing (other than leveraged leasing) is a significant part of the lessor's business activities in terms of revenue, net income, or assets, the financial statements need to include a general description of the leasing arrangements.¹⁹² Additional disclosures are required:

4.8 International Financial Reporting Standards

International Accounting Standard (IAS) 17, Leases, and several Interpretations establish guidance on how to account for leases. The scope of IAS 17 is broader than the scope of Topic 840 (FASB Statement No. 13). IAS 17 applies to all leases other than (1) leases to explore for or use minerals, oil, natural gas and similar nonregenerative resources and (2) licensing arrangements for such items as motion picture films, video recordings, plays, manuscripts, patents, and copyrights.¹⁹⁵ The general principles for the recording of leases are very similar to U.S. GAAP. For example, IAS 17 distinguishes between operating leases and capital leases (called finance leases under IFRS); it establishes criteria for lease classification that are similar to the criteria in FASB Statement No. 13; and it provides for cost deferral of initial direct costs. However, the Standard contains no bright lines, such as a 75% of economic life test or a 90% of fair value test. Rather than bright lines, IAS 17 includes indicators that serve as guidelines for the classification of leases. Additionally, special rules apply for real estate leases of income-producing properties that are accounted for at fair value.

Currently the agendas of both the IASB and the FASB include a project on leases in which the fundamental approach to the accounting for leases is being reconsidered. The project on leases is further discussed in Section 4.1 of this chapter.

4.8.1 Lease Classification

The classification of leases is based on the extent to which risks and rewards of ownership of a leased asset lie with the lessor or the lessee.¹⁹⁶

IAS 17 establishes these classifications for leases for both lessee and lessor:¹⁹⁷

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. IAS 17 provides examples of situations that would normally lead to a lease being classified as a finance lease:¹⁹⁸

Additionally, certain other indicators could lead to a lease being classified as a finance lease:¹⁹⁹

Lease of Real Estate Property

When classifying a lease of real estate property, the land and building elements of the lease are considered separately, unless the amount of the land element is immaterial.²⁰⁰ The minimum lease payments are allocated between land and buildings based on the relative fair values of the leasehold interests in the land and building elements of the lease.²⁰¹ In April 2009, the IASB, as part of its Annual Improvements Project, amended the provisions related to the lease classification of real estate. Before that amendment, the land element of a lease was classified as an operating lease, unless title to the leased land was expected to pass to the lessee by the end of the lease term. Under the revised guidance, no exception is provided for the lease of the land element.²⁰²

If the lease payments cannot be allocated reliably between the land and building elements, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases, in which case the entire lease is classified as an operating lease.²⁰³

Investment Property

Investment property is real estate held by the owner or by a lessee under a finance lease to earn rentals or for capital appreciation or both.²⁰⁴ Special rules have been developed for investment property held under leases (i.e., for situations in which an entity leases investment property (as lessee) and leases that investment property (as sublessor) to other parties):

4.8.2 Accounting and Disclosures—Lessee

4.8.2.1 Finance Leases

Accounting

Lessees recognize finance leases as assets and liabilities in their balance sheets at the lower of the fair value of the leased property or the present value of the minimum lease payments. Initial direct costs may be incurred in connection with specific leasing activities, such as costs incurred in negotiating and securing leasing arrangements. The costs identified as directly attributable to activities performed by a lessee for a finance lease are included as part of the amount recognized as leased asset.²⁰⁸ In calculating the present value of the minimum lease payments, the discount factor is the interest rate implicit in the lease,²⁰⁹ if it is practicable to determine; otherwise, the lessee's incremental borrowing rate should be used.

A finance lease results in depreciation expense as well as finance expense for each accounting period. The depreciation policy for depreciable leased assets should be consistent with that for depreciable assets that are owned, and the depreciation recognized should be calculated according to IAS 16, Property, Plant and Equipment, and IAS 38, Intangible Assets. If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset should be fully depreciated over the shorter of the lease term or its useful life.²¹⁰

Disclosures

For finance leases, lessees are required to disclose:²¹¹

4.8.2.2 Operating Leases

Accounting

Lease payments under an operating lease should be recognized as an expense in the income statement on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user's benefit.²¹²

For operating leases, lease payments (excluding costs for services such as insurance and maintenance) are recognized as an expense in the income statement on a straight-line basis unless another systematic basis is more representative of the time pattern of the user's benefit.²¹³

Disclosures

Lessees should, in addition to the disclosures required by IFRS 7, Financial Instruments: Disclosures, make these disclosures for operating leases:²¹⁴

4.8.3 Accounting and Disclosures—Lessor

4.8.3.1 Finance Leases

Accounting

Under a finance lease, substantially all the risks and rewards of ownership are transferred by the lessor. Lessors should recognize a receivable at an amount equal to the net investment in the lease.²¹⁵ Lease payments are treated by the lessor as repayment of principal and finance income.²¹⁶ Finance income is recognized to reflect a constant periodic rate of return on the lessor's net investment in the finance lease.²¹⁷

A finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income:²¹⁸

The sales revenue recognized at the commencement of a finance lease term by a manufacturer or dealer lessor is the lower of the fair value of the asset or the present value of the minimum lease payments accruing to the lessor, computed at a market rate of interest. The cost of sale recognized at the commencement of the lease term is the cost or carrying amount, if different, of the leased property less the present value of the unguaranteed residual value. The difference between the sales revenue and the cost of sale is the selling profit, which is recognized in accordance with the policy followed by the company for sales.²¹⁹

Initial direct costs incurred by a manufacturer or dealer in connection with negotiating and arranging a finance lease are recognized as an expense at the commencement of the lease term, because they are mainly related to earning the manufacturer's or dealer's selling profit.²²⁰ For finance leases other than leases involving manufacturer or dealer lessors, the initial direct costs are included in the finance lease receivable; they reduce the amount of income recognized over the lease term.²²¹

Disclosures

In addition to the disclosures required by in IFRS 7, lessors need to disclose:²²²

4.8.3.2 Operating Leases

Accounting

Lessors present assets subject to operating leases in their balance sheets according to the nature of the asset.²²³

Lease income from operating leases is recognized in income on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which use benefit derived from the leased asset is diminished.²²⁴

Costs, including depreciation, incurred in earning the lease income are recognized as an expense. Lease income (excluding receipts for services provided, such as insurance and maintenance) is recognized in income on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which use benefit derived from the leased asset is diminished.²²⁵

Initial direct costs incurred in negotiating and arranging an operating lease are added to the carrying amount of the leased asset and recognized as expense over the lease term on the same basis as lease income.²²⁶

The leased assets should be depreciated consistent with the lessor's normal depreciation policy for similar assets, with the depreciation charge being calculated as set forth in IAS 16, Property, Plant and Equipment, and IAS 38, Intangible Assets.²²⁷

Disclosures

For operating leases, lessors should disclose the following in addition to the disclosures required by IFRS 7:²²⁸

4.9 Synopsis of Authoritative Literature (Pre-Codification References)

FASB Statement No. 13, Accounting for Leases

FASB Statement No. 13 establishes lease classification, accounting, and reporting standards for both lessee and lessor. Additionally, the statement provides accounting guidance for sale-leaseback transactions involving personal property. Since its issuance in November 1976, FASB Statement No. 13 has been amended by several FASB Statements and clarified by FASB Interpretations.

FASB Statement No. 23, Inception of the Lease, an amendment of FASB Statement No. 13

In FASB Statement No. 23, the FASB reconsidered the application of FASB Statement No. 13 to leasing transactions in which lessor and lessee agree on lease terms prior to the construction or acquisition of the asset to be leased. The amendments to FASB Statement No. 13 include a redefinition of the term “inception of the lease” to make it the date of the lease agreement or any earlier commitment.

FASB Statement No. 29, Determining Contingent Rentals, an amendment of FASB Statement No. 13

FASB Statement No. 29 defines contingent rentals as the increases or decreases in lease payments that result from changes occurring subsequent to the inception of the lease in the factors on which lease payments are based, with the exception of increases of minimum lease payments relating to increases in the cost of the leased property. Lease payments that depend on a factor that exists and is measurable at the inception of the lease, such as the prime interest rate, would be included in minimum lease payments based on that factor at the inception of the lease. Lease payments that depend on a factor that does not exist or is not measurable at the inception of the lease, such as future sales volume, are considered contingent rentals in their entirety and are excluded from minimum lease payments. Contingent rentals are included in income as they accrue.

FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, an amendment of FASB Statements No. 13, 60, and 65 and a rescission of FASB Statement No. 17

FASB Statement No. 91 establishes accounting and reporting standards for nonrefundable fees and costs associated with lending activities. Loan origination fees and direct costs are deferred and recognized over the life of the loan as an adjustment of yield. The provisions of FASB Statement No. 91 also apply to the accounting for fees and initial direct costs associated with leasing.

FASB Interpretation No. 19, Lessee Guarantee of the Residual Value of Leased Property, an interpretation of FASB Statement No. 13

FASB Interpretation No. 19 clarifies certain provisions in FASB Statement No. 13 relating to a lessee's residual value guarantees:

FASB Interpretation No. 21, Accounting for Leases in a Business Combination, an interpretation of FASB Statement No. 13

FASB Interpretation No. 21 provides that the classification of a lease is not changed as a result of a business combination unless the provisions of the lease are modified. If in connection with a business combination, the provisions of a lease are modified in a way that requires the revised agreement to be considered a new agreement following the provisions of FASB Statement No. 13, this “new” lease is classified according to the lease classification criteria in FASB Statement No. 13.

FASB Interpretation No. 23, Leases of Certain Property Owned by a Governmental Unit or Authority, an interpretation of FASB Statement No. 13

FASB Interpretation No. 23 provides clarification regarding the requirement in paragraph 28 of FASB Statement No. 13 to classify certain leases of property owned by a governmental unit as operating leases.

FASB Interpretation No. 24, Leases Involving Only Part of a Building, an interpretation of FASB Statement No. 13

In FASB Interpretation No. 24, FASB clarifies that the fair value of the leased property involving only part of a building may be objectively determinable, even if there are no sales of property similar to the leased property; evidence, such as an independent appraisal of the leased property or estimated replacement cost information, may provide a basis for an objective determination of fair value.

FASB Interpretation No. 26, Accounting for Purchase of a Leased Asset by the Lessee during the Term of the Lease, an interpretation of FASB Statement No. 13

FASB Interpretation No. 26 clarifies that the termination of a capital lease that results from the purchase of a leased asset by the lessee is an integral part of the purchase of the leased asset; any difference between the purchase price and the carrying amount of the lease obligation is recorded as an adjustment of the carrying amount of the asset.

FASB Interpretation No. 27, Accounting for a Loss on a Sublease, an interpretation of FASB Statement No. 13 and APB Opinion No. 30

This interpretation clarifies that FASB Statement No. 13 does not prohibit the recognition of a loss by a lessee that disposes of leased property or mitigates the cost of an existing lease commitment by subleasing the property.

FASB Staff Position FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period

A lessee may take possession of leased property prior to the lessee commencing operations. During this period, the lessee has the right to use the leased property and does so for the purpose of constructing leasehold improvements. Rental costs relating to the period in which leasehold improvements are constructed should be recognized as rental expense, rather than capitalized.

FASB Staff Position FAS 13-2, Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction

In leveraged lease transactions, the lessor is the owner of the assets for income tax purposes, depreciates the assets, and receives accelerated tax depreciation deductions. FSP FAS 13-2 addresses how a change or projected change in the timing of cash flows relating to income taxes generated by leveraged lease transactions affects the lessor's accounting.

FASB Technical Bulletin No. 79-10, Fiscal Funding Clauses in Lease Agreements

A fiscal funding clause is commonly found in a lease agreement in which the lessee is a governmental unit. A fiscal funding clause generally provides that the lease is cancelable if the legislature or other funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the lease agreement. The existence of a fiscal funding clause in a lease agreement necessitates an assessment of the likelihood of lease cancellation through exercise of the fiscal funding clause. If the likelihood of exercise of the fiscal funding clause is assessed as being remote, a lease agreement containing such a clause is considered a noncancelable lease; otherwise, the lease is considered cancelable.

FASB Technical Bulletin No. 79-11, Effect of a Penalty on the Term of a Lease

Superseded by FASB Statement No. 98.

FASB Technical Bulletin No. 79-12, Interest Rate Used in Calculating the Present Value of Minimum Lease Payments

Paragraph 7(d) of FASB Statement No. 13 generally requires that the lessee use its incremental borrowing rate to calculate the present value of minimum lease payments. FTB 79-12 provides that the lessee's use of a secured borrowing rate is not proscribed by paragraph 5(l) of FASB Statement No. 13, if that rate is determinable, reasonable, and consistent with the financing that would have been used in the particular circumstances.

FASB Technical Bulletin No. 79-13, Applicability of FASB Statement No. 13 to Current Value Financial Statements

FTB 79-13 states that FASB Statement No. 13 is applicable to financial statements prepared on a current value basis.

FASB Technical Bulletin No. 79-14, Upward Adjustment of Guaranteed Residual Values

FASB Statement No. 13 prohibits the upward adjustment of the estimated residual value of sales-type leases, direct financing leases, and leveraged leases. FTB 79-14 provides that this prohibition is also applicable to upward adjustments that result from renegotiations of the guaranteed portions of residual values.

FASB Technical Bulletin No. 79-15, Accounting for Loss on a Sublease Not Involving the Disposal of a Segment

If costs expected to be incurred under an operating sublease exceed anticipated revenue on the operating sublease, a loss should be recognized by the sublessor. Similarly, a loss should be recognized on a direct financing sublease if necessitated by the terms of the transaction.

FASB Technical Bulletin No. 85-3, Accounting for Operating Leases with Scheduled Rent Increases

FTB 85-3 provides that scheduled rent increases included in minimum lease payments under FASB Statement No. 13 should be recognized by lessors and lessees on a straight-line basis over the lease term unless another systematic and rational allocation basis is more representative of the time pattern in which the leased property is physically employed.

FASB Technical Bulletin No. 86-2, Accounting for an Interest in the Residual Value of a Leased Asset: Acquired by a Third Party or Retained by a Lessor That Sells the Related Minimum Rental Payments

The FASB staff has responded to inquiries received as follows:

Accounting for a Residual Value Interest Acquired by a Third Party

The acquisition of an interest in the residual value of a leased asset should be accounted for as the acquisition of an asset, generally at the amount of cash disbursed, the fair value of other consideration given, and the present value of liabilities assumed at the date the right is acquired. Subsequent to initial recognition, any subsequent increase in the fair value of the residual interest would not be recognized; an other-than-temporary decline in value would require a write-down.

Accounting for a Residual Value Interest Retained by a Lessor that Sells the Related Minimum Rental Payments

A lessor retaining an interest in the residual value of the leased asset should not recognize increases in the value of the lease residual over the remaining lease term. Any other-than-temporary declines in value require a write-down to fair value.

FASB Technical Bulletin No. 88–1, Issues Relating to Accounting for Leases: Time Pattern of the Physical Use of the Property in an Operating Lease, Lease Incentives in an Operating Lease, Applicability of Leveraged Lease Accounting to Existing Assets of the Lessor, Money-Over-Money Lease Transactions, Wrap Lease Transactions

The FASB staff responded to inquiries received as follows:

Time Pattern of the Physical Use of the Property in an Operating Lease

If rents escalate in contemplation of the lessee's physical use of the leased property, but the lessee takes possession of or controls the physical use of the property at the beginning of the lease term, all rental payments should be recognized on a straight-line basis. If rents escalate because a lessee gains access to and control over additional leased property, rental expense or rental revenue should be attributed to the additional leased property proportionate to the relative fair value of the additional leased property.

Lease Incentives in an Operating Lease

Incentives in an operating lease should be recognized on a straight-line basis by both the lessee and the lessor.

Applicability of Leveraged Lease Accounting to Existing Assets of the Lessor

The requirement that the carrying amount of a leased asset must equal its fair value at the inception of the lease to qualify as a leveraged lease applies literally to a lease of a lessor's existing assets. The carrying amount of an asset previously placed in service is likely not the same as its fair value; therefore, leveraged lease accounting is generally not appropriate in such circumstance.

Money-over-Money Lease Transactions

In a money-over-money lease transaction, an enterprise manufactures or purchases an asset, leases the asset to a lessee, and obtains nonrecourse financing in excess of the asset's cost using the leased asset and the future lease rentals as collateral. Other than the recognition of manufacturer's or dealer's profit in a sales-type lease, an enterprise should not recognize as income any proceeds from the borrowing in a money-over-money lease transaction at the beginning of the lease term.

Wrap Lease Transactions

A wrap lease transaction is a transaction in which an enterprise purchases an asset, leases the asset to a lessee, obtains nonrecourse financing using the lease rentals or the lease rentals and the asset as collateral, sells the asset subject to the lease and the nonrecourse debt to a third-party investor, and leases the asset back while remaining the substantive principal lessor under the original lease. Wrap lease transactions are accounted for as sale-leaseback transactions. Wrap lease transactions of real estate should be accounted for following the sale-leaseback provisions of FASB Statement No. 98.

EITF Issue No. 85-27, Recognition of Receipts from Made-up Rental Shortfalls

Outline provided in Chapter 1.

EITF

Issue No. 87-7, Sale of an Asset Subject to a Lease and Nonrecourse Financing: “Wrap Lease Transactions.”

Issues.

A lessor may lease an asset to a lessee and obtain nonrecourse financing using the lease receivable and the asset as collateral. The lessor may then sell the asset subject to the lease and the nonrecourse financing to a third party and lease the asset back. The lessor remains the principal lessor with the user of the asset. In exchange for the asset, the lessor receives cash and a note receivable and may also retain an interest in the residual value of the leased asset and remarketing rights.

The issues are:

Consensuses/Status.

The Task Force reached a consensus that any revenue associated with future remarketing rights should be separated from other proceeds received in the transaction, deferred, and recognized in income by the original lessor at the time the remarketing services are performed.

Subsequent to the issuance of EITF Issue No. 87-7, FTB 88-1 was issued, which provides accounting guidance for wrap lease transactions. Wrap leases are accounted for following the guidance for sale-leaseback transactions.

EITF Issue No. 88-3, Rental Concessions Provided by Landlord

Resolved by FTB 88-1 and EITF Issues No. 88-10 and 94-3.

EITF Issue No. 88-10, Costs Associated with Lease Modification or Termination

Issues resolved or nullified by FASB Statement No. 146.

EITF Issue No. 90-15, Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions

Nullified for entities within the scope of the variable interest entity consolidation guidance.

EITF Issue No. 92-1

Allocation of Residual Value or First-Loss Guarantee to Minimum Lease Payments in Leases Involving Land and Building(s).

Issue.

A lease may include a residual value or first-loss guarantee by the lessee. What should the accounting treatment of the guarantee be for purposes of performing the 90% of fair value test?

Consensus/Status.

The Task Force reached a consensus that pursuant to paragraph 26(b)(ii) of FASB Statement No. 13, the annual minimum lease payments applicable to the land are determined for both the lessee and the lessor by multiplying the fair value of the land by the lessee's incremental borrowing rate. The remaining minimum lease payments, including the full amount of the guarantee, are attributed to the building.

If the lease is classified as operating lease, the lessee may have to recognize a liability and provide certain disclosures pursuant to the provisions of FIN 45.

EITF Issue No. 95-17

Accounting for Modifications of an Operating Lease that Do Not Change the Lease Classification.

Issue.

Lessor and lessee may modify an operating lease by shortening the lease term and increasing the lease payments over the shortened lease period; the modifications do not change the lease classification. How should the adjustment to the lease term and the increase in the lease payments over the shortened lease period be accounted for?

Consensus/Status.

The treatment of the increase in the lease payments over the shortened lease period is a matter of judgment that depends on the facts and circumstances: If the increase is in substance a modification of future lease payments, the increase should be accounted for prospectively over the term of the modified lease. If the increase is in substance a termination penalty, it should be charged to income in the period of the modification.

The Task Force established these factors to consider when making that determination:

If the increase in lease payments represents a termination penalty, the amount of the charge may be calculated based on either undiscounted or discounted amounts.

EITF Issue No. 96-21, Implementation Issues in Accounting for Leasing Transactions Involving Special-Purpose Entities

Partially nullified for entities within the scope of FIN 46(R).

Issues Not Nullified.

The issues are:

Consensuses/Status.

EITF Issue No. 97-1, Implementation Issues in Accounting for Lease Transactions, Including Those Involving Special-Purpose Entities.

Issues.

The issues are:

Consensuses/Status.

Regardless of whether these conditions exist, if the lease is part of a sale-leaseback transaction subject to the provisions of FASB Statement No. 98, a default remedy that allows the buyer-lessor to put the leased property to the seller-lessee would violate the continuing involvement criteria in FASB Statement No. 98; therefore, the transaction is accounted for by the deposit method or as a financing, whichever is appropriate under FASB Statement No. 66.

EITF Issue No. 97-10, The Effect of Lessee Involvement in Asset Construction.

Issue.

A lessee may be involved on behalf of an owner-lessor with the construction of an asset that will be leased to the lessee when construction of the asset is completed. How should a lessee that is involved with the construction of an asset that it will lease when construction is completed determine whether it should be considered the owner of that asset during the construction period?

Consensus/Status.

The Task Force reached a consensus that a lessee should be considered the owner of a real estate project during the construction period if the lessee has substantially all of the construction period risks. An evaluation of whether the lessee has substantially all of the construction period risks should be based on a test that is similar to the 90% of fair value test described in paragraph 7(d) of FASB Statement No. 13.

If the documents governing the construction project could require, under any circumstance, that the lessee pay 90% or more of the total project costs (excluding land acquisition costs) as of any point in time during the construction period, the lessee should be deemed to have substantially all of the construction period risks and should be considered to be the owner of the real estate project during the construction period.

Additionally, a lessee should be considered the owner of a real estate project during construction, even if the 90% test just described is not violated, if certain other conditions outlined in that EITF Issue and EITF Issues No. 96-21 and 97-1 are met.

EITF Issue No. 98-9, Accounting for Contingent Rent.

Issues.

Some rental agreements provide for minimum rental payments plus contingent rents based on the lessee's operations, such as a future specified sales target. The issues are:

Consensuses/Status.

EITF Issue No. 99-13, Application of EITF Issue No. 97-10 and FASB Interpretation No. 23 to Entities That Enter into Leases with Governmental Entities.

Issue.

Should projects for the construction of government-owned properties involving a lease of the completed improvements that would be classified as an operating lease under FIN 23 be excluded from the scope of EITF Issue No. 97–10?

Consensus/Status.

The Task Force reached a consensus that the construction of government-owned properties subject to a future lease of the completed improvements should be included in the scope of EITF Issue No. 97–10.

EITF Issue No. 99-14, Recognition by a Purchaser of Losses on Firmly Committed Executory Contracts.

Issue.

When should a purchaser under a firmly committed executory contract recognize an impairment of its remaining contractual right asset under the contract, and how should that impairment loss be measured if the purchaser will continue to use the asset or service to be received under the contract?

Consensus/Status.

The Task Force discontinued discussions of this Issue. No consensus was reached.

EITF Issue No. 00-11, Lessors' Evaluation of Whether Leases of Certain Integral Equipment Meet the Ownership Transfer Requirements of FASB Statement No. 13

Issues.

The issues are:

Consensuses/Status.

EITF Issue No. 00-26, Recognition by a Seller of Losses on Firmly Committed Executory Contracts.

Issues.

The issues are:

Consensuses/Status.

The Task Force discontinued discussions of this Issue. Consensuses were not reached.

EITF Issue No. 01-8, Determining Whether an Arrangement Contains a Lease.

Issue.

Paragraph 1 of FASB Statement No. 13 defines a lease as “an agreement conveying the right to use property, plant, or equipment (land and/or depreciable assets) usually for a stated period of time.”

How should one determine whether an arrangement contains a lease that is within the scope of FASB Statement No. 13?

Consensus/Status.

The evaluation of whether an arrangement contains a lease within the scope of FASB Statement No. 13 is based on the substance of the arrangement using the following guidance:

If an arrangement contains a lease and nonlease elements, the classification, recognition, measurement, and disclosure requirements of FASB Statement No. 13 are applied to the lease element of the arrangement. Payments and other considerations are separated into those for the lease and those for other services on a relative fair value basis consistent with the guidance in paragraph 4(a) of EITF Issue No. 00-21.

EITF Issue No. 01-12, The Impact of the Requirements of FASB Statement No. 133 on Residual Value Guarantees in Connection with a Lease

Issues.

There is a scope overlap between FASB Statement No. 13 and FASB Statement No. 133, for certain residual value guarantees.

The issues are:

Consensuses/Status.

EITF Issue No. 05-6, Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination

Issues.

The issues are:

Consensuses/Status.

EITF Issue No. 08-2, Lessor Revenue Recognition for Maintenance Services

Issue.

Leasing arrangements may require the lessor to maintain the leased asset during the lease term. How should a lessor recognize revenue related to maintenance services?

Consensus/Status.

The Task Force reached a tentative conclusion that revenue related to maintenance services should be recognized into income as those services are performed utilizing a proportional performance method. The issue was removed from the agenda, without a consensus being reached.

EITF Issue No. 08-3, Accounting by Lessees for Maintenance Deposits

Issue.

A lessee may be responsible for repair and maintenance of the leased asset throughout the lease term. Certain lease agreements include provisions requiring the lessee to make maintenance deposits to the lessor. How should the lessee account for such maintenance deposits?

Consensus/Status.

The Task Force reached a consensus that maintenance deposits should be accounted for as a deposit asset. When an amount on deposit is less than probable of being returned, that amount shall be recognized as additional expense.

EITF Topic No. D-8, Accruing Bad-Debt Expense at Inception of a Lease

Recognition of bad debts should be based on the guidance provided in FASB Statement No. 5.

EITF Topic No. D-107, Lessor Consideration of Third-Party Residual Value Guarantees

The SEC staff has taken the position that when determining lease classification, lessors should not include residual value guarantees for a portfolio of leased assets in the amount of minimum lease payments, because residual value guarantees of a portfolio of leased assets preclude the lessor from determining the amount of the guaranteed residual value of any individual leased asset within the portfolio at lease inception.

International Accounting Standard 17, Leases

IAS 17 establishes lease classification, accounting, and reporting standards for lessors and lessees; the general principles underlying the accounting and reporting for leases are similar to the provisions in FASB Statement No. 13.

IFRIC Interpretation 4, Determining whether an Arrangement Contains a Lease

Issues.

The issues are:

Consensuses.

IFRIC Interpretation 12, Service Concession Arrangements

Issues.

In some countries, governments have introduced contractual service arrangements to attract private sector participation in the development, financing, operation, and maintenance of infrastructure for public services, such as roads, bridges, tunnels, prisons, hospitals, airports, and energy supply and telecommunication networks. The issues are:

Consensuses.

The IFRIC developed a comprehensive model to address the accounting for service concession arrangements. Service concession arrangements are not within the scope of the leasing guidance governed by IAS 17.²³⁵

SIC Interpretation 15, Operating Leases—Incentives

Issue.

In negotiating an operating lease, the lessor may provide incentives for the lessee to enter into the agreement. How should incentives in an operating lease be recognized in the financial statements of both the lessee and the lessor?

Consensus.

The Standing Interpretations Committee (SIC) reached the following consensus: All such incentives should be recognized as an integral part of the net consideration agreed for the use of the leased asset, irrespective of the incentive's nature or form or the timing of payments. The benefit (lessee) or cost (lessor) of the incentive is recognized as a reduction of rental expense (lessee) or income (lessor) on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern over which the use is derived (lessee) or the benefit of the leased asset is diminished (lessor).

SIC Interpretation 27, Evaluating the Substance of Transactions Involving the Legal Form of a Lease

Issues.

When an arrangement between unrelated parties is made in the legal form of a lease, the issues are:

Consensuses.

Notes

1. Accounting Standards Codification (ASC) 840-10-20 (FASB Statement (FAS) No. 13, paragraph 1).

2. ASC 840-10-15-9 (FAS 13, paragraph 1, footnote 1).

3. ASC 840-10-15-15 (FAS 13, paragraph 1).

4. While the guidance in Emerging Issues Task Force (EITF) Issue No. 01-8 does not need to be applied to an arrangement entered into before an entity's reporting period beginning before May 29, 2003, a change in the contractual terms of an arrangement and arrangements acquired in business combinations generally require a reassessment (EITF Issue No. 01-8, paragraphs 13 and 16).

5. ASC 840-10-10-1 (FAS 13, paragraph 60).

6. Snapshot: Leases; International Accounting Standards Board staff, August 2010.

7. FASB Technical Plan and Project Update—Leases.

8. Other than for short-term leases, as outlined below.

9. Under International Financial Reporting Standards (IFRS), a lessee could revalue its right-of-use assets.

10. Other than for short-term leases, as outlined ahead.

11. For purposes of this exception, a short-term lease is defined as a lease that, at the commencement of the lease, has a maximum possible term, including any options to renew, of 12 months or less.

12. Under the current IFRS lease guidance, leases of intangibles are within the scope of the lease guidance (with some exceptions).

13. ASC 840-10-20 (FAS 13, paragraph 1).

14. Whether a take-or-pay contract is subject to the Leases guidance, subject to derivatives accounting rules, or to neither of these depends on its terms. The Leases guidance should be applied first, as leases within the scope of Topic 840 (FASB Statement No. 13) are not derivative instruments subject to the accounting for derivative instruments. However, a derivative embedded in a lease would be subject to the accounting for derivative instruments (EITF Issue No. 01–8, paragraphs B18–B20).

15. ASC 840-10-55-32 – 55-34 (EITF Issue No. 01-8, Exhibit 01-8A, Example 2).

16. ASC 840-10-55-26 (EITF Issue No. 01-8, paragraph B9).

17. Adapted from ASC 840-10-55-30 and 55-31 (EITF Issue No. 01-8, Exhibit 01-8A, Example 1).

18. ASC 840-10-35-2 (EITF Issue No. 01-8, paragraph 13).

19. Other than extensions and renewals [ASC 840-10-35-2 (EITF Issue No. 01–8, paragraph 13(a))].

20. ASC 840-10-35-2(b) (EITF Issue No. 01-8, paragraph 13(b)).

21. Adapted from ASC 840-10-35-2(d) (EITF Issue No. 01-8, paragraph 13(d)).

22. The term “lease inception” is defined as the date of the lease agreement or commitment, if earlier. That commitment must be in writing, signed by the parties in interest to the transaction, and specific as to the principal provisions of the transaction. If any of the principal provisions are yet to be negotiated, such a preliminary agreement or commitment does not qualify for purposes of this definition [ASC840-10-20 (FAS 13, paragraph 5(b))].

23. ASC 840-10-25-29 and 25-1 (FAS 13, paragraph 7).

24. If investment tax credits are retained by the lessor: The threshold for meeting this criterion is 90% of the fair value of the leased property less any investment tax credits expected to be realized by the lessor [ASC 840-10-25-1(d) (FAS 13, paragraph 7(d))].

25. ASC 840-10-25-5 (FAS 13, paragraph 5(j)).

26. The incremental borrowing rate is the rate that the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. A lessee is not proscribed from using its secured borrowing rate as its incremental rate if that rate is determinable, reasonable, and consistent with the financing that would have been used in the particular circumstance [ASC 840-10-20 (FAS 13, paragraph 5(l); FASB Technical Bulletin (FTB) 79-12)].

27. ASC 840-10-25-31 (FAS 13, paragraph 7(d)).

28. ASC 840-10-25-43 (FAS 13, paragraph 6); special rules apply for extensions and renewals, see Section 4.6.1.2 in this chapter.

29. ASC 840-10-25-43 (FAS 13, paragraph 8).

30. ASC 840-10-25-41 (FAS 13, paragraph 7(d)): “The discount rate that causes the aggregate present value at the beginning of the lease term of the minimum lease payments . . . to be equal to the fair value of the leased property to the lessor at lease inception, minus any investment tax credit retained by the lessor and expected to be realized by him” [ASC 840-10-20 (FAS 13, paragraph 5(k))].

31. ASC 840-10-25-43(c) (FAS 13, paragraph 42).

32. ASC 840-30-25-8 (paragraph 43 of FASB Statement No. 13) provides that the net of the balances of the following accounts represents the lessor's [net] investment in leveraged leases:

33. Additionally, lessors need to consider whether collectibility of the minimum lease payments is reasonably predictable and whether there are uncertainties regarding the amount of unreimbursable costs that will be incurred by the lessor under the lease [ASC 840-10-25-42 (FAS 13, paragraph 8(a) and (b))]

34. ASC 840-10-35-1(a) (FAS 13, paragraph 11(a)).

35. ASC 840-10-35-1(b) (FAS 13, paragraph 11(b)).

36. ASC 840-10-25-1(a) (FAS 13, paragraph 7(a)).

37. ASC 840-10-25-50 (EITF Issue No. 00-11, paragraph 5).

38. The term “penalty” has been defined rather broadly in ASC 810-40-20 (FASB Statement No. 13, paragraph 5(o)). A penalty is any requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to do any of the following: disburse cash; incur or assume a liability; perform services; surrender or transfer an asset or rights to an asset or otherwise forego an economic benefit, or suffer an economic detriment.

39. Glossary (ASC 840-10-20; FAS 13, paragraph 5(f)).

40. ASC 840-10-25-3 (FASB Technical Bulletin (FTB) No. 79-10).

41. ASC 840-10-20 (FAS 13, paragraph 5(e)).

42. ASC 840-10-20 (FAS 13, paragraph 5(o)).

43. ASC 840-10-25-5 (FAS 13, paragraph 5(j)(i)).

44. ASC 840-10-25-7 (FAS 13, paragraph 5(j)(ii)).

45. ASC 840-10-25-31 and 25-41 (FAS 13, paragraph 7(d)).

46. The interest rate implicit in the lease is defined in ASC 840-10-20 (FASB Statement No. 13, paragraph 5(k)).

47. ASC 840-10-25-14 (EITF Issue No. 97-1, Question 2).

48. Note that although the amount of potential penalty is considered a minimum lease payment for purposes of lease classification, it would not be accrued over the term of the lease.

49. ASC 840-10-25-18 (FAS 13, paragraph 24).

50. ASC 840-10-25-25 (FAS 13, paragraph 28); see Section 4.4.4.1 for further discussion.

51. ASC 840-10-25-55 and 25-56 (FAS 13, paragraph 25).

52. ASC 840-10-25-57 and 25-58 (FAS 13, paragraph 25).

53. ASC 840-10-25-59 (FAS 13, paragraph 25).

54. “If the lease agreement or commitment, if earlier, includes a provision to escalate minimum lease payments for increases in construction or acquisition cost of the leased property or for increases in some other measure of cost or value, such as general price levels, during the construction or preacquisition period, the effect of any increases that have occurred is taken into consideration when determining the fair value of the leased property at lease inception.” [ASC 840-10-25-38(a) (FAS 13, paragraph 26(a)(i), footnote 22a)].

55. Land capitalized under a lease that transfers title or contains a bargain purchase option is generally not amortized [ASC 840-30-35-3 (FAS 13 paragraph 26(a)(i))].

56. ASC 840-30-35-1(b) (FAS 13, paragraph 11(b)).

57. ASC 840-10-25-38-b(1)(ii) (FAS 13, paragraph 26(b)(i)(a)).

58. ASC 840-10-25-38(b)(2) (FAS 13, paragraph 26(b)(ii)(a)).

59. ASC 840-10-25-61 (FAS 13, paragraph 26(a)(ii)).

60. ASC 840-10-25-62 (FAS 13, paragraph 26(a)(iii)).

61. If fair value does not equal the carrying amount, the lease would be classified as operating lease.

62. ASC 840-10-25-63 (FAS 13, paragraph 26(b)(i)).

63. If fair value does not equal the carrying amount, the lease would be classified as operating lease.

64. ASC 840-10-25-64 (FAS 13, paragraph 26(b)(i)(b)).

65. ASC 840-10-25-66 (FAS 13, paragraph 26(b)(ii)).

66. The allocation of the minimum lease payments is based on the methodology outlined in Section 4.4.2.1; the minimum lease payments (after deducting executory costs including any profits thereon) applicable to the land and building are separated by determining the fair value of the land and applying the lessee's incremental borrowing rate to it to determine the annual minimum lease payments applicable to the land element. The remaining minimum lease payments are attributed to the building element [ASC 840-10-25-67 (FAS 13, paragraph 26(b)(ii))].

67. If fair value does not equal the carrying amount, the lease is classified as an operating lease.

68. ASC 840-10-25-68 (FAS 13, paragraph 26(b)(ii)(b)).

69. At a minimum, the decrease in the value of the equipment as a result of its removal is the estimated cost to ship and reinstall the equipment at a new site [ASC 360-20-15-4 through 15-8 (EITF Issue No. 00–13, paragraph 4)].

70. ASC 840-10-25-19 and 25-20 (FAS 13, paragraph 27).

71. ASC 840-10-25-23 (FAS 13, paragraph 28(a)).

72. ASC 840-10-25-39 (FAS 13, paragraph 28(a)(ii)).

73. ASC 840-30-35-1(b) (FAS 13, paragraph 11(b)).

74. By virtue of its power to abandon a facility during the term of the lease, the governmental body can effectively control the lessee's continued use of the property for its intended purpose, thus making its economic life indeterminate (FAS 13, paragraph 106 (not codified)).

75. ASC 840-10-25-25 (FASB Interpretation (FIN) No. 23, paragraphs 8 and 9).

76. ASC 840-10-25-25 (FAS 13, paragraph 28).

77. ASC 840-10-25-23 (FAS 13, paragraph 28).

78. ASC 840-10-25-69 (FAS 13, paragraph 28(b)).

79. ASC 840-20-25-1 (FAS 13, paragraph 15; FTB 85-3).

80. ASC 840-30-25-1; ASC 840-30-30-1 – 30-3 (FAS 13, paragraph 10).

81. ASC 840-30-35-6 (FAS 13, paragraph 12).

82. ASC 840-35-35-7 (FAS 13, paragraph 12).

83. ASC 840-30-35-1(b) (FAS 13, paragraph 11(b)).

84. ASC 840-20-25-1 (FAS 13, paragraph 19(b)).

85. ASC 840-20-25-2(a) (FTB 85-3).

86. ASC 840-20-25-4 and 25-5 (FTB 88-1, Question 1).

87. ASC 840-20-25-16 – 25-20 (FAS 13, paragraph 19(c)).

88. ASC 840-20-25-6 (FTB 88-1, Question 2); see Section 4.6.7 in this chapter for further discussion of lease incentives in operating leases.

89. ASC 840-30-25-6 (FAS 13, paragraph 17).

90. The minimum lease payments include guaranteed residual value.

91. ASC 840-30-35-25 (FAS 13, paragraph 17(d)); ASC 840-30-35-25 provides: “A lessor shall review the estimated residual value of a leased property at least annually. If the review results in a lower estimate than had been previously established, the lessor shall determine whether the decline in estimated residual value is other than temporary. If the decline in estimated residual value is judged to be other than temporary, the accounting or the transaction shall be revised using the changed estimate and the resulting reduction in the net investment shall be recognized by the lessor as a loss in the period in which the estimate is changed. An upward adjustment of the leased property's estimated residual value (including any guaranteed portion) shall not be made.”

92. ASC 840-30-35-22 (FAS 13, paragraph 17(b)).

93. The presentation in the lessor's financial statements will differ based on the facts and circumstances of the transaction. If the asset is inventory from the perspective of the lessor, the lessor presents sales and cost of goods sold. If the leased asset is classified as property, plant, and equipment, the lessor records gain on sale rather than sales and cost of goods sold.

94. In a sales-type lease, initial direct costs are included in the cost relating to the sale. (See discussion in Section 4.5.2.2. in this chapter)

95. However, the exercise of a renewal option included as part of the original lease term for which exercise was reasonably assured is not a renewal or extension of a lease in this context.

96. Special rules apply to capital leases with residual value guarantees or penalties for failure to renew the lease, as outlined later in this section.

97. ASC 840-30-35-17(b) (FAS 13, paragraph 14(b)).

98. ASC 840-30-35-20; ASC 840-40-15-6 (FAS 13, paragraph 14).

99. Special rules apply to capital leases with residual value guarantees or penalties for failure to renew the lease, as outlined later in this section.

100. ASC 840-30-35-17 and 35-19 (FAS 13, paragraph 14(a) and (b)).

101. ASC 840-30-35-8 (FAS 13, paragraph 14).

102. For leases involving real estate, sales-type lease classification is appropriate only if title to the leased asset is transferred.

103. ASC 840-30-25-5 (FAS 13, paragraph 17(a)).

104. See ASC 840-10-55-45 and 55-46 (FTB 88-1) for further discussion.

105. Special rules apply to leases with residual value guarantees or penalties for failure to renew the lease.

106. ASC 840-30-35-28(b) (FAS 13, paragraphs 17(f)(ii)(b) and 18(c)).

107. A renewal or extension that occurs in the last few months of an existing lease is considered to have occurred at or near the end of the existing lease term [ASC 840-10-25-51 (FAS 13, paragraph 6(b)(i) footnote 9a)].

108. ASC 840-10-25-51 (FAS 13, paragraph 17(f)(ii)(c); paragraph 18(c)).

109. In direct financing leases, the carrying amount and fair value of the leased property are the same at the inception of the lease. An exception arises when an existing sales-type or direct financing lease is renewed or extended during the term of the existing lease. In such cases, the fact that the carrying amount of the property at the end of the original lease term is different from its fair value at that date does not preclude the classification of the renewal or extension as a direct financing lease [ASC 840-10-25-52 (FAS 13, paragraph 6(b)(ii))].

110. ASC 840-30-35-25 (FAS 13, paragraph 17(f)(ii)(a); FAS 13, paragraph 17(f)(i); FAS 13, paragraph 18(c)).

111. ASC 840-30-35-25 (FAS 13, paragraph 17(f)(i); FAS 13, paragraph 17(d)).

112. ASC 840-30-25-25 (FAS 13, paragraph 17(d)).

113. Except that no upward adjustment of the estimated residual value is permitted [ASC 840-30-25-25 (FAS 13, paragraph 17(d) and 17(e))].

114. ASC 840-30-35-23 (FAS 13, paragraph 17(e); FAS 13, paragraph 18(c)).

115. ASC 840-10-35-4 (FAS 13, paragraph 9).

116. For example, if lease rentals are modified, the lease rentals used for calculating minimum lease payments at the inception of the lease should be those specified in the original lease up to the date of modification and the modified rentals thereafter.

117. The provisions of the revised lease would not have resulted in a different lease classification of the lease had the changed terms been in effect at the inception of the lease.

118. ASC 840-30-35-19 (FAS 13, paragraph 14(a)).

119. ASC 840-40-15-6; ASC 840-30-35-20 (FAS 13, paragraph 14(a)).

120. ASC 840-10-35-4; ASC 840-30-30-1 – 30-3 (FAS 13, paragraphs 9 and 10).

121. Section 4.6.3.3 of this chapter discusses considerations to be made when determining whether lease modifications should be considered lease terminations.

122. ASC 840-30-35-30 (FAS 13, paragraph 17(f)(i)).

123. ASC 840-30-35-30 (FAS 13, paragraph 17(f)(i)).

124. ASC 840-30-35-30 and 35-25 (FAS 13, paragraphs 17(f)(i) and 17(d)).

125. ASC 840-30-40-6 (FAS 13, paragraph 17(f)(i)).

126. For leases involving real estate, sales-type lease classification is appropriate only if title to the leased asset is transferred.

127. See ASC 840-10-55-46 (FTB 88-1) for further discussion.

128. ASC 840-30-40-1 (FAS 13, paragraph 14(c)).

129. ASC 840-30-40-7 (FAS 13, paragraph 17(f)(iii); FAS 13, paragraph 18(c)).

130. ASC 840-20-55-4 – 55-6 (EITF Issue No. 95-17).

131. Costs to terminate capital leases are not within the scope of Subtopic 420-10 (FASB Statement No. 146). They are addressed in ASC 840-30-40-1 (paragraph 14(c) of FASB Statement No. 13) [ASC 420-10-15-3 (FAS 146, paragraph 2(b))].

132. ASC 420-10-30-10 (FAS 146, paragraph 3).

133. ASC 420-10-25-2 (FAS 146, paragraph 4).

134. ASC 420-10-25-1 (FAS 146, paragraph 3).

135. ASC 420-10-35-1 – 35-4 (FAS 146, paragraph 6).

136. ASC 420-10-30-8 (FAS 146, paragraph 16).

137. ASC 420-10-35-1 – 35-4 (FAS 146, paragraphs 6 and 16).

138. Adapted from ASC 420-10-55-11 – 55-15 (FASB Statement No. 146, paragraph A11, Example 4).

139. The expected net cash flows of $100,000 ($25,000 per year for the remaining lease term of 4 years) are discounted using a credit-adjusted risk free rate of 8%.

140. Calculated as: $100,000 rental expense less $83,333 rentals from sublease.

141. ASC 840-30-40-1 (FAS 13, paragraph 14(c)).

142. FIN 26, paragraph 4 (not codified).

143. Subtopic 360-20 (FASB Statement No. 66) does not permit the deferral of a loss on sale.

144. ASC 840-20-25-2 (FTB 85-3; FTB 88-1).

145. ASC 840-20-25-3 (FTB 88-1, paragraph 2(b)).

146. ASC 840-20-25-3 (FAS 13, paragraph 15; FTB 85-3).

147. ASC 840-20-25-4 (FTB 88-1, paragraph 2(b)).

148. ASC 840-10-20 (FAS 13, paragraph 5(n); FAS 29, paragraph 8).

149. FAS 29, paragraph 7 (not codified).

150. ASC 840-10-25-4 (FAS 13, paragraph 5(n)); FAS 29, Appendix A (not codified).

151. ASC 840-10-25-4 (paragraph 5(n) of FASB Statement No. 13) provides, in part: “[L]ease payments that depend on an existing index or rate, such as the consumer price index or the prime interest rate, shall be included in minimum lease payments based on the index or rate existing at lease inception; any increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals and thus affect the determination of income as accruable.”

152. ASC 450-20-25-2 (FAS 5, paragraph 8).

153. ASC 840-10-40-1 (EITF Issue No. 98-9).

154. Adapted from ASC 605-10-S99 (SEC Staff Accounting Bulletin (SAB) Topic 13.A.4.c. (SAB 101)).

155. ASC 605-10-S99 (SAB Topic 13.A.4.c. (SAB 101)); Note: ASC 840-10-50-5 provides: “The lessor shall disclose its accounting policy for contingent rental income. If a lessor accrues contingent rental income before the lessee's achievement of the specified target (provided achievement of that target is considered probable), disclosure of the impact on rental income shall be made as if the lessor's accounting policy was to defer contingent rental income until the specified target is met.” That guidance indicates that there may be situations in which a lessor could recognize contingent rentals before a specified target has been met. However, as the Codification was not intended to establish new accounting guidance, it is the author's view that it is not appropriate for lessors to accrue contingent rental income before a specified target has been achieved, consistent with the guidance in EITF Issue No. 98-9 and the guidance provided by the SEC in ASC 605-10-S99 (SAB Topic 13.A.4.c (SAB 101)).

156. ASC 840-20-25-6 – 25-7 (FAS 13, paragraph 15; FTB 85-3; FTB 88-1).

157. Adapted from ASC 840-20-55-1 – 55-3 (FTB 88–1).

158. $800,000 (annual payment on assumed lease) less $550,000 (sublease income) = $250,000/year over 4 years.

159. Letter dated February 7, 2005, addressed to the Center for Public Audit Firms.

160. ASC 840-10-35-10 (FAS 13, paragraph 36).

161. ASC 840-10-40-3 (FAS 13, paragraph 37).

162. ASC 840-30-40-5 (FAS 13, paragraphs 38(a) and (b)).

163. ASC 840-20-40-1 (FAS 13, paragraph 38(c)).

164. ASC 840-30-35-12 (FAS 13, paragraphs 7 and 8).

165. ASC 840-30-35-12 (FAS 13, paragraph 39(b)).

166. ASC 840-20-25-14 (FAS 13, paragraph 39(c)).

167. ASC 840-10-25-32 (FAS 13, paragraph 40).

168. ASC 840-1025-1 (FAS 13, paragraph 7).

169. ASC 840-10-35-5 (FIN 21, paragraph 13); additionally, arrangements entered into prior to the effective date of EITF Issue No. 01-8 lose their grandfathering upon any substantive modification alter the effective date of the consensus in EITF Issue No. 01-8.

170. EITF Issue No. 01–3 (not codified).

171. EITF Issue No. 05-6, codified in ASC 840-10-35-6 and 35-7.

172. ASC 360-10-15-4 (FAS 144, paragraph 3).

173. ASC 360-10-35-23 (FAS 144, paragraph 10).

174. Impairment considerations for long-lived assets to be disposed of are not addressed in this section.

175. ASC 360-10-35-17 (FAS 144, paragraph 7).

176. Costs to terminate a contract that is a capital lease are not within the scope of FASB Statement No. 146 [ASC 420-10-15-3 (FAS 146, paragraph 2)].

177. ASC 420-10-25-11 (FAS 146, paragraph 14).

178. ASC 840-20-25-15 and ASC 840-30-35-13 (FTB 79–15).

179. See Section 4.6.7 for further discussion.

180. See Section 5.2.2.1 in Chapter 5 for further discussion.

181. Excluded from the build-to-suit guidance described in this section is any entity that is a lessee (or that has an option to become a lessee) under a lease agreement in which the lessee's maximum obligation including guaranteed residual values represents a minor amount of the asset's fair value.

182. ASC 840-40-55-15 (EITF Issue No. 97-10).

183. ASC 840-40-55-15(b)(3) (EITF Issue No. 97-10).

184. ASC 840-40-55-15(e) (EITF Issue No. 97-10).

185. ASC 840-40-55-15(f) (EITF Issue No. 97-10).

186. ASC 840-40-55-15 and 55-16 (EITF Issue No. 97-10).

187. If the lessee is acting in the capacity of a general contractor, the lessee's own actions or failures to act include the actions or failures to act of its subcontractors.

188. ASC 840-10-50-1 (FAS 13, paragraph 29).

189. FAS 13, paragraph 30 (not codified).

190. ASC 840-20-45-2 and 45-3 (FAS 13, paragraph 13).

191. ASC 840-20-50-1 and 50-2 (FAS 13, paragraphs 16(b) and 16(c)).

192. ASC 840-10-50-4 (FAS 13, paragraph 23).

193. ASC 840-30-50-4 (FAS 13, paragraph 23).

194. ASC 840-20-50-4 (FAS 13, paragraph 23(b)).

195. Under U.S. GAAP, the scope of the leases guidance is more narrow; it is limited to leases of property, plant and equipment.

196. International Accounting Standard (IAS) 17, paragraph 7.

197. IAS 17, paragraph 9.

198. IAS 17, paragraph 10.

199. IAS 17, paragraph 11.

200. For a lease of land and buildings in which the amount that would initially be recognized for the land element is immaterial, the land and buildings may be treated as a single unit for the purpose of lease classification and classified as a finance or operating lease in accordance with paragraphs 7 to 13. In such a case, the economic life of the building element is regarded as the economic life of the entire leased asset (IAS 17, paragraphs 15A and 17).

201. IAS 17, paragraph 16.

202. IAS 17, paragraph 15A.

203. IAS 17, paragraph 16.

204. IAS 40, paragraph 5.

205. IAS 17, paragraph 18.

206. IAS 17, paragraph 19; IAS 40, paragraph IN5.

207. IAS 17, paragraph 19.

208. IAS 17, paragraphs 20 and 24.

209. The interest rate implicit in the lease is defined as the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor (IAS 17, paragraph 4).

210. IAS 17, paragraph 27.

211. IAS 17, paragraph 31; these disclosures are in addition to the disclosure requirements under International Financial Reporting Standard (IFRS) 7.

212. IAS 17, paragraph 33.

213. IAS 17, paragraph 34.

214. IAS 17, paragraph 35

215. IAS 17, paragraph 36.

216. IAS 17, paragraph 37.

217. IAS 17, paragraph 39.

218. IAS 17, paragraph 43.

219. IAS 17, paragraph 44.

220. IAS 17, paragraph 46.

221. IAS 17, paragraph 38.

222. IAS 17, paragraph 47.

223. IAS 17, paragraph 49.

224. IAS 17, paragraph 50.

225. IAS 17, paragraph 51.

226. IAS 17, paragraph 52.

227. IAS 17, paragraph 53.

228. IAS 17, paragraph 56.

229. EITF Issue No. 96-21, Question No. 4.

230. EITF Issue No. 96-21, Question No. 6.

231. EITF Issue No. 96-21, Question No. 10.

232. EITF Issue No. 96-21, Question No. 11.

233. EITF Issue No. 96-21, Question No. 12.

234. SAB Topic 13.A.4.c.

235. IFRIC Interpretation No. 4, paragraph 4b.