ASC 840, Leases, and its subtopics establish standards of accounting and reporting by lessees and lessors for leases overall, and for specific classifications of leases. ASC 840 contains four subtopics:

ASC 840-10, Overall,
ASC 840-20, Operating Leases
ASC 840-30, Capital Leases
ASC 840-40, Sale-Leaseback Transactions.

Each of the subtopics contains the following Subsections:

General
Lessees
Lessors.

Scope and Scope Exceptions

ASC 840 applies to all entities. However, to be considered a lease the right to use property, plant, or equipment must be transferred from one contracting party to the other. The definition of lease does not include contracts for services.

Overview

Lease transactions became enormously popular over the years as businesses sought new ways to finance long-lived assets. Leasing offered two attractive advantages: (typically) 100% financing, coupled with (very often) off-the-books obligations.

There are several economic reasons why the lease transaction is considered a viable alternative to outright purchase, which are:

The lessee (borrower) is frequently able to obtain 100% financing.
Income tax benefits may be available to one or both of the parties.
The lessor receives the equivalent of interest as well as an asset with some remaining residual value at the end of the lease term.
In some cases, equipment or other assets are not available for outright purchase.

A lease agreement involves at least two parties, a lessor and a lessee, and an asset that is to be leased. The lessor, the party that either owns or commits to purchase the asset, agrees to grant the lessee the right to use it for a specified period of time in return for periodic rent payments.

The lease transaction derives its accounting complexity from the number of alternatives available to the parties involved. Leases can be structured to allow differing assignments of income tax benefits associated with the leased asset to meet the objectives of the transacting parties. Leases can be used to transfer ownership of the leased asset, and they can be used to transfer the risks and rewards of ownership. In any event, the substance of the transaction dictates, with certain exceptions, the accounting treatment, irrespective of its legal form. The lease transaction is probably the best example of the accounting profession's substance-over-form argument. If the transaction effectively transfers the risks and rewards of ownership to the lessee, then the substance of the transaction is that of a sale and, accordingly, it is recognized as such for accounting purposes even though the transaction is legally structured as a lease.

Variable interest entities.

There later developed the practice of using nonsubstantive lessors (which often were related entities) to assist in keeping leases off the statement of financial position of lessees. These entities were frequently used to exclude liabilities from the lessee's consolidated statement of financial position in order to more favorably portray the lessee's financial condition. ASC 810, Consolidation, remediated much of the confusion created by the original interpretation. Under the provisions of ASC 810, many more lessor entities are required to be consolidated with the financial statements of the lessee, especially in situations where the lessor and lessee have common or related-party ownership.

It is necessary for the lessee to first apply ASC 810 to evaluate its relationship with the lessor and, in that respect, ASC 810 takes precedence over ASC 840, Leases. This is because if ASC 810 requires the lessee to consolidate the lessor, the effects of the lease transaction between the parties will be removed from the consolidated financial statements via an eliminating entry and, consequently, the consolidated reporting entity will depreciate the leased asset and reflect all of the costs of acquiring, holding, maintaining, and disposing of the asset. This makes the issue of distinguishing between operating and financial leases moot for any leases between a Variable Interest Entity (VIE) and its primary beneficiary.

The lessor will, of course, in any separately issued financial statements, account for the lease in accordance with the appropriate lease accounting requirements that would apply absent ASC 810. Certain concepts and definitions discussed herein are also explained in the chapter on ASC 810 but are repeated and expanded upon here for completeness and further clarification in the context of lease transactions.

DEFINITIONS OF TERMS

Acquiree. The business or businesses that the acquirer obtains control over in a business combination. This term also includes a nonprofit activity or business that a not-for-profit acquirer obtains control of in an acquisition by a not-for-profit entity.

Acquirer. The entity that obtains control of the acquiree. However, in a business combination in which a VIE is acquired, the primary beneficiary of that entity always is the acquirer.

Bargain purchase option. A provision allowing the lessee, at his option, to renew the lease for a rental sufficiently lower than the fair rental of the property at the date the option becomes exercisable that exercise of the option appears, at lease inception, to be reasonably assured. Fair rental of a property in this context shall mean the expected rental for equivalent property under similar terms and conditions.

Bargain renewal option. A provision allowing the lessee, at his option, to renew the lease for a rental sufficiently lower than the fair rental of the property at the date the option becomes exercisable that exercise of the option appears, at lease inception, to be reasonably assured. Fair rental of a property in this context shall mean the expected rental for equivalent property under similar terms and conditions.

Capital Lease. From the perspective of a lessee, a lease that meets any of the four lease classification criteria in ASC 840-10-25-1:

Transfer of ownership. The lease transfers ownership of the property to the lessee by the end of the lease term. This criterion is 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, for example, the minimum required by statutory regulation to transfer title.
Bargain purchase option. This option is included in the lease.
Lease term. The lease term is equal to 75% or more of the estimated economic life of the leased property. However if the beginning of the lease term falls within the last 25% of the total estimated economic life of the lease property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.
Minimum lease payment. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executor costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90% of the excess of the fair value of the leased property to the lessor at lease exception over any related investment tax credit retained by the lessor and expected to be realized by the lessor. If the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

Contingent rentals. The increases or decreases in lease payments that result from changes occurring after lease inception in the factors (other than the passage of time) on which lease payments are based, excluding any escalation of minimum lease payments relating to increases in construction or acquisition cost of the leased property or for increases in some measure of cost or value during the construction or pre-construction period. The term contingent rentals contemplates an uncertainty about future changes in the factors on which lease payments are based.

Estimated economic life. The estimated remaining period during which the property is expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at lease inception, without limitation by the lease term.

Estimated residual value of leased property. The estimated fair value of the leased property at the end of the lease term.

Fair value of leased property. The price that would be received to sell the property in an orderly transaction on the measurement date between market participants that are not related parties.

When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease will ordinarily be its normal selling price net of volume or trade discounts. In some cases, due to market conditions, fair value may be less than the normal selling price or even the cost of the property.

When the lessor is not a manufacturer or dealer, the fair value of the property at the inception of the lease will ordinarily be its cost net of volume or trade discounts. However, if a significant amount of time elapses between the acquisition of the property by the lessor and the inception of the lease, fair value is determined in light of market conditions prevailing at the inception of the lease. Thus, fair value may be greater or less than the cost or carrying amount of the property.

Fair value determinations made for lease classification or measurement purposes are to be performed as defined by ASC 840, not as later set forth by ASC 820, other than as pertains to business combinations accounted for under ASC 805. For acquisition accounting applications, ASC 820 is the relevant guidance to be followed.

Incremental borrowing rate. The rate that, at lease inception, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. This definition does not proscribe the lessee's use of a secured borrowing rate as its incremental borrowing rate if that rate is determinable, reasonable, and consistent with the financing that would have been used in the particular circumstances.

Initial direct costs. Only those costs incurred by the lessor that are (1) costs to originate a lease incurred in transactions with independent third parties that (a) result directly from and are essential to acquire that lease and (b) would not have been incurred had that leasing transaction not occurred, and (2) certain costs directly related to specified activities performed by the lessor for that lease. Those activities are: evaluating the prospective lessee's financial condition; evaluating and recording guarantees, collateral, and other security arrangements; negotiating lease terms; preparing and processing lease documents; and closing the transaction. The costs directly related to those activities include only that portion of the employees' total compensation and payroll-related fringe benefits directly related to time spent performing those activities for that lease and other costs related to those activities that would not have been incurred but for that lease. Initial direct costs do not include costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, and other ancillary activities related to establishing and monitoring credit policies, supervision, and administration. Initial direct costs do not include administrative costs, rent, depreciation, any other occupancy and equipment costs and employees' compensation and fringe benefits related to activities described in the previous sentence, unsuccessful origination efforts, and idle time.

Interest Rate Implicit in the Lease. The discount rate that causes the aggregate present value at the beginning of the lease term of the minimum lease payments (as described in paragraph 840-10-25-4), excluding that portion of the payments representing executory costs to be paid by the lessor, together with any profit thereon and the unguaranteed residual value, accruing to the benefit of the lessor 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. If the lessor is not entitled to any excess of the amount realized on disposition of the property over a guaranteed amount, no unguaranteed residual value would accrue to its benefit.

Interest Method. The method used to arrive at a periodic interest cost (including amortization) that will represent a level effective rate on the sum of the face amount of the debt and (plus or minus) the unamortized premium or discount and expense at the beginning of each period.

Lease. An agreement conveying the right to use property, plant, or equipment (land or depreciable assets or both), usually for a stated period of time.

Lease Incentive. An incentive for the lessee to sign the lease, such as an up-front cash payment to the lessee, payment of costs for the lessee (such as moving expenses), or the assumption by the lessor of the lessee's preexisting lease with a third party.

Lease Inception. The date of the lease agreement or commitment, if earlier. For purposes of this definition, a commitment shall be in writing, signed by the parties in interest to the transaction, and shall specifically set forth 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.

Lease term. The fixed noncancelable term of the lease plus the following:

Periods covered by bargain renewal options
Periods for which failure to renew the lease imposes a penalty on the lessee in an amount such that renewal appears, at the inception of the lease, to be reasonably assured
Periods covered by ordinary renewal options during which a guarantee by the lessee of the lessor's debt directly or indirectly related to the leased property is expected to be in effect, or a loan from the lessee to the lessor directly or indirectly related to the leased property is expected to be outstanding
Periods covered by ordinary renewal options preceding the date that a bargain purchase option is exercisable
Periods representing renewals or extensions of the lease at the lessor's option.

However, the lease term does not extend beyond the date a bargain purchase option becomes exercisable or beyond the useful life of the leased asset.

Minimum lease payments. For the lessee: The payments that the lessee is or can be required to make in connection with the leased property. Contingent rental guarantees by the lessee of the lessor's debt, and the lessee's obligation to pay executory costs, are excluded from minimum lease payments (MLPs). Additionally, if a portion of the MLPs representing executory costs is not determinable from the provisions of the lease, an estimate of executory costs is excluded from the calculation of the minimum lease payments. If the lease contains a bargain purchase option, only the minimum rental payments over the lease term and the payment called for in the bargain purchase option are included in minimum lease payments. Otherwise, MLPs include the following:

The minimum rental payments called for by the lease over the lease term
Any guarantee of residual value at the expiration of the lease term made by the lessee (or any party related to the lessee), whether or not the guarantee payment constitutes a purchase of the leased property. When the lessor has the right to require the lessee to purchase the property at termination of the lease for a certain or determinable amount, that amount is considered a lessee guarantee. When the lessee agrees to make up any deficiency below a stated amount in the lessor's realization of the residual value, the guarantee to be included in the MLP is the stated amount rather than an estimate of the deficiency to be made up. ASC 840 provides additional guidance regarding residual guarantees, as follows:
1. Lease provisions requiring the lessee to reimburse the lessor for residual value deficiencies due to damage, extraordinary wear and tear, or excessive usage are analogous to contingent rentals, since at the inception of the lease, the amount of the deficiency is not determinable. Therefore, these payments are not included in the MLP as residual value guarantees.
2. Some leases contain provisions limiting the lessee's obligation to reimburse the lessor for residual value deficiencies to an amount less than the stipulated residual value of the leased property at the end of the lease term. In computing the MLP associated with these leases, the amount of the lessee's guarantee is limited to the specified maximum deficiency the lessee can be required to reimburse to the lessor.
3. A lessee may contract with an unrelated third party to guarantee the residual for the benefit of the lessor. The MLP can only be reduced by the third-party guarantee to the extent that the lessor explicitly releases the lessee from the obligation to make up the deficiency, even if the guarantor defaults. Amounts paid by the lessee to the guarantor are executory costs and are not included in the MLP.
Any payment that the lessee must or can be required to make upon failure to renew or extend the lease at the expiration of the lease term, whether or not the payment would constitute a purchase of the leased property.

For the lessor: The payments described above, plus any guarantee of the residual value or of the rental payments beyond the lease term by a third party unrelated to either the lessee or lessor (provided the third party is financially capable of discharging the guaranteed obligation).

Noncancelable in this context means that a lease is cancelable only if one of the following conditions is satisfied:

A remote contingency occurs
The lessor grants permission
The lessee enters into a new lease with the same lessor
The lessee pays a penalty in an amount such that continuation of the lease appears, at inception, reasonably assured.

Nonrecourse financing. Lending or borrowing activities in which, in the event of default, the collateral available to the creditor is limited to certain assets that are specifically agreed to in the loan agreement, and that collateral does not include the general assets of the debtor.

Penalty. Any requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to pay 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.

Primary beneficiary. A variable interest holder that is required to consolidate a VIE. Consolidation is required when the holder of one or more variable interests would absorb a majority of the VIE's expected losses, receive a majority of the VIE's expected residual returns, or both. If one holder would absorb a majority of the VIE's expected losses and another holder would receive a majority of the VIE's expected residual returns, the holder absorbing the majority of the expected losses is the primary beneficiary and is thus required to consolidate the VIE.

Profit or Loss on Sale. The profit or loss that would be recognized on the sale if there were no leaseback. For example, on a sale of real estate subject to Topic 360, the profit on the sale to be deferred and amortized in proportion to the leaseback would be the profit that could otherwise be recognized in accordance with Topic 360.

Profit recognition. Any method to record a transaction involving real estate, other than the deposit method, or the methods to record transactions accounted for as financing, leasing, or profit-sharing arrangements. Profit recognition methods commonly used to record transactions involving real estate include, but are not limited to, the full accrual method, the installment method, the cost recovery method, and the reduced profit method.

Sale-leaseback accounting. A method of accounting for a sale-leaseback transaction in which the seller-lessee records the sale, removes all property and related liabilities from its statement of financial position, recognizes gain or loss from the sale, and classifies the leaseback in accordance with this section.

Unguaranteed residual value. The estimated residual value of the leased property, exclusive of any portion guaranteed by the lessee, by any party related to the lessee, or any party unrelated to the lessee. If the guarantor is related to the lessor, the residual value is considered unguaranteed.

Unrelated parties. All parties that are not related parties as defined above.

Variable interest. Ownership, contractual, or other monetary interests in an entity that are either entitled to received expected favorable variability (“expected residual returns”) or obligated to absorb expected unfavorable variability (“expected losses”).

Variable interest entity. An entity financially controlled by parties that are not its majority voting owners. Financial control is evidenced by a controlling party being exposed to the majority of the financial risks associated with the VIE performing worse than expected, or being entitled to the majority of the rewards associated with the VIE performing better than expected. This situation arises either because (1) the entity's at-risk equity is insufficient to absorb its expected losses or (2) because the entity's at-risk equity holders do not meet all three criteria necessary to be considered to possess a controlling financial interest in the entity.

CONCEPTS, RULES, AND EXAMPLES

Variable Interest Entities

The complex and evolving rules for lease accounting from the standpoint of the lessee and of the lessor are set forth in this chapter. From the standpoint of the lessee, it is critical for the accountant to first determine whether the relationship between the entities requires consolidation as a VIE under ASC 810, which is discussed in detail in the chapter on ASC 810. If consolidation is required, the effects of the lease recorded by the parties will be eliminated in the consolidated financial statements and the lease accounting will, in effect, be moot from the standpoint of the lessee.

In essence, a VIE is an entity that, by design, is not funded with an amount of at-risk equity sufficient to enable it to sustain itself in the face of reasonably possible losses without obtaining additional support (“subordinated financial support”) from existing or additional sources. In practical terms, in the context of leasing, the lessee is at risk for an amount greater than the contractual rental payments—such as for the lessor's debt arising from financing the leased property.

Determination of whether an entity is a VIE involves analysis of the individual facts, circumstances, relationships, structures, risks, and rewards associated with the entity and the parties with whom it is involved. Often, especially when related parties are involved, this analysis can be performed qualitatively without laborious numeric estimates of expected variability. That is because even a superficial review of the relationships and transaction details will reveal that the entity in question is indeed a VIE, or that it clearly is not one.

In more complex situations, however, or when qualitative analysis does not yield a conclusive answer, the holder of one or more variable interests may be required to estimate the present value of the probability-weighted expected cash flows associated with the entity in order to determine the expected variability of the entity's future cash flows as well as the portion of that expected variability that is allocable to the various holders of variable interests.

Decision diagrams.

The following decision diagrams are used to discuss the illustrative examples of leasing transactions presented in this chapter.

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Definition of a business.

A business is defined, in the context of ASC 810, as

. . . a self-sustaining integrated set of activities and assets conducted and managed for the purpose of providing a return to investors. A business consists of (a) inputs, (b) processes applied to those inputs, and (c) resulting outputs that are used to generate revenues. For a set of activities and assets to be a business, it must contain all of the inputs and processes necessary for it to conduct normal operations, which include the ability to sustain a revenue stream by providing its outputs to customers.

In evaluating whether an entity is a business, consideration must be given to unique factors relating to the industry and the activities being performed including

Inputs

Fixed assets either owned or leased
Intangibles either owned or licensed
Access to materials or rights needed to perform its activities
Employees.

Processes

Strategic management
Operations
Resource management.

Outputs

Access to customers (clients).

A three-step process is provided in order to assess whether a set of activities (“set”) qualifies as a business:

Identify elements included in the “set” (i.e., determine the existing inputs, processes, and outputs.)
Compare the elements identified in item 1 to the elements necessary for the set of activities to be conducted as a normal business operation.
If any elements are missing, assess the degree of effort or investment relative to the fair value of the set of activities needed to acquire or gain access to the missing elements. If a significant effort or investment would be required, it can be concluded that the set of activities is not a business; conversely, a de minimus amount of effort or investment to supply the missing elements would lead to the conclusion that the set of activities is a business.

Variable interests in “silos.”

A party may hold a variable interest in specific assets of a VIE (e.g., a guarantee or a subordinated residual interest). In computing expected losses and expected residual returns, as defined above, a holder of a variable interest in specified assets of a VIE must determine if the interest it holds qualifies as an interest in the VIE itself. The variable interest is considered an interest in the VIE itself if either (1) the fair value of the specific assets is more than half of the total fair value of the VIE's assets, or (2) the interest holder has another significant variable interest in the entity as a whole.

If the interests are deemed to be interests in the VIE itself, the expected losses and expected residual returns associated with the variable interest in the specified assets are treated as being associated with the VIE.

If the interests are not deemed to be interests in the VIE itself, the interests in the specified assets are treated as a separate VIE (referred to as a “silo”) if the expected cash flows from the specified assets (and any associated credit enhancements, if applicable) are essentially the sole source of payment for specified liabilities or specified other interests. Under this scenario, expected losses and expected residual returns associated with the silo assets are accounted for separately to the extent that the interest holder either bears the expected losses or is entitled to receive the expected returns. Any excess of expected losses or residual returns not borne (received) by the variable interest holder is considered attributable to the entity as a whole.

If one interest holder is required to consolidate a silo of a VIE, other VIE interest holders are to exclude the silo from the remaining VIE.

Example of application of ASC 810 to related-party leases

The most commonly encountered potential VIE situations that occur in practice involve related-party leases. Business owners often organize a partnership or LLC (for this discussion we will assume an LLC) to own property that is leased to a business with the same or similar ownership. The transaction is structured in this manner for a number of reasons that include avoidance of double taxation of the gain on the eventual sale of the property and legal protection of the building from creditors of the operating business in the event of business bankruptcy.

In attempting to avoid lessee capitalization, the lease is often structured with a short initial term (e.g., three years), with the lessee having successive options to renew the lease at similar terms. The building is pledged as collateral under a mortgage with a third-party lender. The lessor entity is thinly capitalized (i.e., it has very little owner-invested equity). Consequently, the lender, besides holding a mortgage on the building as collateral, has further protected its interests by obtaining a loan guarantee from the lessee, an assignment of rents, and a personal guarantee of the owner.

These relationships are illustrated in the following diagram:

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Analysis under ASC 810

Following the decision diagrams and using the related-party/de facto principal and agent rules included in ASC 810:

The lessee holds a variable interest in the lessor in the form of the guarantee of the lessor's mortgage debt.
The lessor entity is not “scoped out” of ASC 810.
The lessor entity is a business. It has inputs (owned fixed assets), processes for managing its investment, and outputs relative to access to the lessee.
The following “further evaluation factors” apply:
1. The lessee/variable interest holder and its related parties participated significantly in the design of the lessor.
2. The design of the lessor LLC results in all of its activities involving and being conducted on behalf of the lessee/variable interest holder.
3. The lessee/variable interest holder and its related parties provided 100% of the subordinated financial support for the lessor entity.
4. The lessor entity's activities relate to a single-lessee lease.
The lessee/evaluator and its related-party owner were involved in the design of the lessor entity.
The lessee's variable interest is assumed to be significant for the purpose of this analysis. ASC 810 does not provide guidance on making this determination.
The lessee's variable interest is in the leased asset.
The fair value of the leased asset represents 100% of the total fair value of the lessor's assets and thus is deemed to be an interest in the lessor as a whole versus an interest in just the specified assets of the lessor.
The at-risk equity holder of the lessor does not meet the second criterion for being considered to hold a controlling financial interest (i.e., the variable interest holder/lessee could potentially absorb expected losses of the lessor should the lessee be called upon by the lender to perform under the guarantee of the lessor's indebtedness). Note that, in this case, the other two criteria for controlling financial interest are met.
As a result of the analysis up to this point, it can be concluded that the lessor is a variable interest entity.
No silos exist, since 100% of the fair value of the assets is leased to the single lessee.
Application of the related-party/de facto principal and agent rules to the variable interests in the lessor indicates that 100% of the expected losses and expected residual returns from the lessor are allocable to the members of the related-party group (the lessee and the related-party owner of both). Thus, collectively, the lessee and its 100% stockholder are the primary beneficiary of the VIE/lessor. The party most closely associated with the leased property is the lessee who, consequently, is considered the primary beneficiary that is required to consolidate the lessor in its financial statements.

Other lease terms and provisions.

The following discussion examines the effect that certain changes to the above facts would have on the foregoing conclusions:

Existence or absence of guarantees. Even if the stockholder/member's guarantee of the mortgage is not required by the lender and only the lessee guaranteed the debt, the analysis above would be identical. Due to the fact that the lessee/variable interest holder is exposed to the expected losses of the lessor under the terms of the guarantee, the lessor/LLC's sole member (and at-risk equity holder) is not the only party that potentially would absorb expected losses of the lessor.

Conversely, when ASC 810 was originally issued, many observers initially believed if the lessee was not required by the lender to guarantee the mortgage, and the only guarantee was that of the stockholder/member, that the absence of an explicit variable interest held by the lessee would preclude the conclusion that the lessor was a VIE.

This situation illustrates one of the most misunderstood provisions of ASC 810—referred to as an implicit variable interest—which the FASB staff attempts to clarify in ASC 810-10-25.

Even though the lessee did not directly guarantee the debt of the lessor, consideration must be given to the likely scenarios if the lessor/LLC should be close to a default on the mortgage payments. Realistically, what is the likelihood that the sole stockholder/sole member would perform under his or her personal guarantee obligation rather than directing the lessee to pay additional rent sufficient to enable the LLC to keep its mortgage payments current?

Clearly, it would not make economic sense for the sole stockholder/member to perform personally under the guarantee, as this would, in substance, result in the stockholder/member making a loan or capital contribution to an otherwise insolvent LLC. Instead, it would logically follow that the best course of action would be for the lessee to pay rent in amounts adequate to fund the LLC's mortgage payments so that the lessee would continue to have use of the leased premises without concern over whether the bank will foreclose on and sell the property to a third party. If the lessee were having difficulty funding the rent payments, its owner would probably authorize it to borrow money or sell assets in order to enable it to do so before its owner used personal funds to perform under the guarantee.

After analyzing this situation, with appropriate attention to the substance rather than simply its form, it can be seen that the lessee is the holder of an implicit variable interest in the lessor in the form of an implicit guarantee of the lessor's mortgage debt.

The remainder of the analysis would be identical to what was presented earlier. Due to the fact that the lessee/variable interest holder is exposed to the expected losses of the lessor under the terms of the implicit guarantee, the lessor/LLC's sole member (and at-risk equity holder) is not the only party that potentially would absorb expected losses of the lessor.

Finally, consider the situation where neither the lessee nor the owner is required to guarantee the debt. A prudent lender would probably not waive both guarantees unless the lessor was sufficiently capitalized by the owner's at-risk equity. That is, there is a presumption that the lessor in such an instance is not a VIE. Under this scenario, the lessee would perform the quantitative analysis required to estimate expected losses and estimated residual returns to determine whether the lessor is a VIE and, if it is, whether it is the primary beneficiary.

Above- or below-market rentals. Rentals due under related-party leases sometimes exceed arm's-length market rentals because the owner is using the lessor as a conduit for the lessee to indirectly provide additional salary or dividends to the owner (characterized as the excess rent).

Under ASC 810, an operating lease is generally not considered to be a variable interest unless:

The lease terms include a lessee residual guarantee of the fair value of the leased asset, since this results in the lessee potentially absorbing estimated negative variability that would otherwise be absorbed by the equity holder of the lessor
The lease terms include an option for the lessee to purchase the property at the end of the lease term at a specified price, since this means that the lessee potentially may receive estimated positive variability that would otherwise be received by the equity holder of the lessor
The lease terms are not indicative of market terms for a similar property in the same geographic location, since this would result in the lessee either receiving estimated positive variability of the lessor (if the lease terms were below market) or absorbing negative variability of the lessor (if the lease terms were above market).

Under each of the foregoing scenarios, the lease is considered a variable interest in determining the primary beneficiary, because the expected losses of the lessor that would be borne by the lessee (the excess of the rentals required over the fair value of the right to use the leased property) exceed the amounts that would have been expected had the rentals been at fair value. Thus, the stockholder/member would not be considered to have a controlling financial interest, since s/he was not the only party exposed to the lessor's expected losses.

If the situation reversed, and the rentals were below market amounts, it could be logically concluded that the lessor was absorbing negative variability of the lessee and that, therefore, the lease was a variable interest in the lessee held by the lessor that could potentially result in the lessor being considered the primary beneficiary of the lessee that would necessitate the lessor consolidating the lessee in its financial statements.

Other contractual arrangements. Leases are often accompanied by other contractual arrangements between the lessee and lessor. Such contractual arrangements can include management, marketing, brokerage, and other types of service agreements. These agreements must be carefully analyzed, as ASC 810 provides restrictive rules that often result in such agreements being characterized as variable interests.

All parties affected by these transactions should seek expert professional advice prior to either structuring a new transaction or modifying an existing transaction. For example, adverse income tax consequences could result from the transfer of property from one form of ownership to another.

Example: Arm's-length leases—computing expected losses and expected residual returns

The application of ASC 810 is, of course, not limited to related-party arrangements. The following is an example of the quantitative analysis (versus the qualitative analysis illustrated in the related-party example above) that might be necessary in an arm's-length leasing arrangement.

Lawrence Lessor, LLC (referred to herein as “the Entity” since it is the entity that the variable interest holders will be evaluating as to whether it is a VIE) is a limited liability company organized specifically for the purpose of building, owning, and operating a single-lessee retail discount warehouse club store on land that it has recently acquired. The store is the only asset owned by the Entity. The 148,000 square foot store will be occupied by Clubco, a nationally known chain that is unrelated to Lawrence Lessor.

The Entity's voting owners (the LLC members) wish only to invest a minimal amount of equity in the Entity and, consequently, the mortgage lender insisted on obtaining a third-party guarantee of the mortgage which Lawrence obtained from an unrelated third party and for which Lawrence paid a premium.

The terms of the lease with the retailer are as follows (assumed to be an operating lease):

Description of space	148,000 square foot retail discount warehouse club store
Lessee	Clubco Stores, Inc.
Initial lease term	Three years
Lease commencement date	1/1/2011
Annual base rent	$600,000
Contingent rent	1% of annual sales over $30 million
Purchase options:	$9 million—not a bargain purchase option in accordance with ASC 840
Residual guarantee	Lessee guarantees to lessor that residual value of the building at the end of the lease term will be at least equal to the $7,500,000 fair value of the store land and building at inception or it will pay the lessor the difference
Executory costs	All real estate taxes, maintenance, insurance, and common area expenses are to be borne by the lessee

The construction has been completed, the occupancy permits issued, and the construction financing settled with the proceeds of a 25-year, 6% mortgage loan on December 1, 2011. The mortgage loan is guaranteed by an unrelated third-party guarantor. The store is opening and commencing business on January 1, 2012.

Mortgage details are as follows:

Summary Amortization Schedule for Mortgage

25-year, 6% mortgage, original principal amount of $7,275,750

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The Entity's recorded aggregate carrying amount of $7,500,000 for the land and building represents the fair value at lease inception with the land's fair value representing 10%, or $750,000.

The rental terms for the store are considered to be at market rates. If the terms were not at market rates, additional expected variability would be assigned to the lease (in addition to the expected variability resulting from the purchase option and residual value guarantee).

Expected cash flows are discounted to their present value using an assumed 3% interest rate representing the interest rate available on risk-free investments. To simplify the example, cash flows are assumed to occur at the end of each annual period for the purpose of discounting them to present value. A copy of the statement of financial position from the Entity's annual partnership return at lease inception is as follows:

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Analysis by Clubco (See the decision diagrams earlier in this chapter.)

Clubco holds a variable interest in Lawrence Lessor (“the Entity”) in the form of the lease. Expected variability results from the purchase option and the residual value guarantee.
The Entity is not scoped out of ASC 810.
The Entity is a business.
Further evaluation factor d applies; that is, this is a single-lessee lease.
Clubco was not involved in the design of the Entity.
For illustrative purposes, assume that the purchase option is significant to Clubco.
Clubco holds a variable interest in the leased store (the specified assets) in the form of the lease containing a purchase option and residual value guarantee.
The fair value of the building leased by Clubco is 100% of the fair value of the Entity's assets. Therefore, Clubco is deemed to hold a variable interest in the Entity as a whole.
In applying the test to determine if the members of the LLC/entity have a controlling financial interest (distinguished from a controlling voting interest, which they clearly have), the following results are determined:
1. The LLC members are the sole voting interest holders and, therefore, meet the voting test.
2. The LLC members are not the only parties that absorb expected losses of the lessor due to the existence of the residual value guarantee provision in the lease that potentially could result in Clubco bearing a portion of the expected losses.
3. The LLC members are also not the only parties entitled to receive the expected residual returns from the property due to the existence of the purchase option provision in the lease that potentially could result in Clubco receiving a portion of the expected residual returns.
As a consequence of the analysis up to this point, Clubco can conclude that its variable interest is in a lessor that is a VIE.
Since Clubco leases 100% of the fair value of the assets held by entity, there are no silos included therein.
To determine whether or not it is the primary beneficiary of the VIE/lessor, Clubco must determine whether it either will bear the majority of the expected losses, or receive the majority of the expected residual returns. One form this calculation might take is illustrated below.

Note that, in the forecast for 2014, the effects of the purchase option and residual value guarantee are ignored. They are considered later in the analysis of which variable interest holders participate in expected losses and expected residual returns.
Calculation of probability-weighted discounted expected cash flows.

This computation uses the expected cash flow methodology prescribed by CON 7, which is also used in estimation of fair value for the purposes of impairment testing of goodwill and tangible long-lived assets, and in computing asset retirement obligations.
Calculations of expected losses and expected residual returns (and the related expected variability).

ASC 810 requires consideration of the “expected variability” inherent in the estimate of probability-weighted expected cash flows; in this case $3,036,745. This amount represents a weighted-average of the various expected outcomes multiplied by their respective probabilities. As is always the case when averaging numbers, the sums of the positive and negative differences between each value included in the average and the average itself are always equal. This explains why the expected losses and expected residual returns each equal $624,113. Therefore, the expected variability in both directions is the sum of the two absolute values (i.e., $624,113 + $624,113 = $1,248,226).

Another important point to note is that the terms “expected losses” and “expected residual returns” are not associated with traditional GAAP income or cash flow measures. The entity illustrated above has positive expected cash flows under all six scenarios for all three years. Notwithstanding that fact, the computation shows that it will experience expected losses and expected residual returns—variations from expectation, positive or negative, that could occur as a result of operations or of changes in the fair value of the property. This will always be the case, irrespective of how profitable an entity is or how much cash flow it generates.
For each scenario, the facts are analyzed to determine which of the variable interest holders will bear the expected losses. There were no silos included in the VIE; therefore, only a single primary beneficiary determination is required. The results of the analysis are aggregated as follows:

Total equity at risk is $225,250, which would not be sufficient for the entity to absorb the expected losses of $624,113 without receiving additional subordinated financial support. Consequently, the Entity (Lawrence Lessor, LLC) by definition is a VIE.

Note that, based on the analysis of the expected losses, no variable interest holder will absorb a majority (>50%) of the Entity's losses. Consequently, the expected residual returns need to be analyzed.
Since 100% of the expected residual returns will be received by Clubco, it is the primary beneficiary, the party that is required to consolidate Lawrence Lessor, LLC in its financial statements.

Lease or Sale—The Interplay of Lease and Revenue Recognition Accounting

ASC 840-10-35: Determining whether an arrangement contains a lease.

ASC 840 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.” ASC 840-10-35 provides guidance on determining when all or part of an arrangement constitutes a lease.

Scope of ASC 840-10-35. Property, plant, or equipment, as the term is used in ASC 840, includes only land and/or depreciable assets. Therefore, inventory (including equipment parts inventory) cannot be the subject of a lease because inventory is not depreciable. Although specific property, plant, or equipment may be explicitly identified in an arrangement, it is not the subject of a lease if the arrangement can be fulfilled without using the specified property, plant, or equipment. For example, if the owner/seller is obligated to deliver a specified quantity of goods or services but can provide those goods or services using property, plant, or equipment other than that specified in the arrangement, then the arrangement does not contain a lease.

In addition, ASC 840 contains specific scope exceptions with respect to agreements concerning

Exploration or exploitation of natural resources (e.g., oil, gas, minerals, and timber).
Intangible licensing rights (e.g., motion pictures, plays, manuscripts, patents, and copyrights).

Lease treatment is not precluded in situations where the owner or manufacturer of the property has extended a product warranty that includes a provision for replacement of the property if it is not operating adequately. Similarly, if the arrangement includes a provision permitting the equipment owner the right to substitute other equipment on or after a specified date, irrespective of the reason, the arrangement can still qualify as a lease.

Right to use property, plant, or equipment. The right to use the specified property, plant, or equipment is conveyed if any one of the following conditions is met:

A party (for the purpose of this discussion, we will refer to this party, the potential lessee, as “the recipient” of the rights) has the ability or right to operate the property, plant, or equipment or direct others to do so as the recipient specifies, while attaining or controlling more than a minor portion of the output (or service utility),
The recipient has the ability or right to control physical access to the specified property, plant, or equipment while attaining or controlling more than a minor portion of the output (or other service utility), or
Analysis of the relevant facts and circumstances indicates that it is remote (as that term is used in ASC 450-20) that a party (or parties) other than the recipient will attain more than a minor amount of the output (or other service utility) that will be produced or generated by the specified property, plant, or equipment during the term of the arrangement, and the price that the recipient will pay for the output is neither contractually fixed per unit of output nor equal to the market price per unit of output at the time delivery of the output is received.

Timing of initial assessment and subsequent reassessments. The assessment of whether an arrangement contains a lease is to be made at the inception of the arrangement. A reassessment of whether the arrangement contains a lease is to be made only if (a) the contractual terms are modified, (b) a renewal option is exercised or the parties to the arrangement agree on an extension of its term, (c) there is a change in the determination as to whether or not fulfillment of the arrangement is dependent on the property, plant, or equipment that was originally specified, or (d) the originally specified property and equipment undergoes a substantial physical change. Remeasurement/redetermination is not permitted merely because of a change in an estimate made at inception (e.g., the number of expected units of output or the useful life of the equipment).

Aggregation of separate contracts. There is a rebuttable presumption that separate contracts between the same parties (or related parties) that are executed on or near the same date were negotiated together as a package.

This issue also provides accounting guidance for any recognized assets and liabilities existing at the time that an arrangement (or a portion of an arrangement) either ceases to qualify as a lease or commences to qualify as a lease due to a reassessment in the circumstances as described above.

Sales with a guaranteed minimum resale value.

To provide sales incentives, manufacturers sometimes include in a sales contract, a guarantee that the purchaser will, upon disposition of the property, receive a minimum resale amount. Upon disposition, the manufacturer either reacquires the property at the agreed-upon minimum price or reimburses the purchaser for any shortfall between the actual sales proceeds and the guaranteed amount.

ASC 605-50-60 states that transactions containing guarantees of resale value of equipment by a manufacturer are to be accounted for as leases and not as sales. The minimum lease payments used to determine if the criteria have been met for lessor sales-type lease accounting, described later in this chapter, are computed as the difference between the proceeds received from the transferee/lessee upon initial transfer of the equipment and the amount of the residual value guarantee on its first contractual exercise date.

If the lease is accounted for as an operating lease because it does not qualify for sales-type lease accounting (as discussed and illustrated later in this chapter), the manufacturer/lessor is to record the proceeds received at inception as a liability, which is subsequently reduced by crediting revenue pro rata from the inception of the lease until the first guarantee exercise date so that, on that exercise date, the remaining liability is the guaranteed residual amount. If the lessee elects, under the terms of the arrangement, to continue to use the leased asset after the first exercise date, the manufacturer/lessor will continue to amortize the liability for the remaining residual amount to revenue to reduce it further to any remaining guarantee, if applicable.

The foregoing prescribed accounting is followed by manufacturers even when there is dealer involvement in the transaction when it is the manufacturer who is responsible for the guarantee to the purchaser.

ASC 460-10-55-17 states that ASC 460-10-55 does not apply to these transactions irrespective of whether they are accounted for as operating leases or sales-type leases because, in either case, the underlying of such a guarantee is an asset owned by the guarantor.

Equipment sold and subsequently repurchased subject to an operating lease.

ASC 605-15-25-5 specifies that if four conditions are satisfied, a manufacturer can recognize a sale at the time its product is transferred to a dealer for subsequent sale to a third-party customer, even if this ultimate customer (the dealer's customer) enters into an operating lease agreement with the same manufacturer or the manufacturer's finance affiliate.

The dealer must be an independent entity that conducts business separately with manufacturers and customers,
The passage of the product from the manufacturer to the dealer fully transfers ownership,
The manufacturer (or finance affiliate) has no obligation to provide a lease arrangement for the dealer's customer, and
The dealer's customer is in control of selecting which of the many financing options available will be used.

Lessee Classification

For accounting and reporting purposes the lessee has two possible classifications for a lease.

Operating
Capital.

The proper classification of a lease is determined by the circumstances surrounding the transaction. According to ASC 840, if substantially all of the benefits and risks of ownership have been transferred to the lessee, the lessee records the lease as a capital lease at its inception. Substantially all of the risks or benefits of ownership are deemed to have been transferred if any one of the following criteria is met:

The lease transfers ownership to the lessee by the end of the lease term.
The lease contains a bargain purchase option.
The lease term is equal to 75% or more of the estimated economic life of the leased property, and the beginning of the lease term does not fall within the last 25% of the total economic life of the leased property.
The present value of the minimum lease payments at the beginning of the lease term is 90% or more of the fair value to the lessor less any investment tax credit retained by the lessor. This requirement cannot be used if the lease's inception is in the last 25% of the useful economic life of the leased asset. The interest rate, used to compute the present value, is the incremental borrowing rate of the lessee unless the implicit rate is available and lower. For the purpose of this test, lease structuring fees or lease administration fees paid by the lessee to the lessor are included as part of the minimum lease payments (ASC 840-10-25).

If a lease agreement meets none of the four criteria set forth above, it is classified as an operating lease by the lessee.

Lessor Classification

There are four possible classifications that apply to a lease from the standpoint of the lessor.

Operating
Sales-type
Direct financing
Leveraged.

The conditions surrounding the origination of the lease determine its classification by the lessor. If the lease meets any one of the four criteria specified above for lessees and both of the qualifications set forth below, the lease is classified as either a sales-type lease, direct financing lease, or leveraged lease depending upon the conditions present at the inception of the lease.

Collectibility of the minimum lease payments is reasonably predictable
No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease.

If a lease transaction does not meet the criteria for classification as a sales-type lease, a direct financing lease, or a leveraged lease as specified above, it is classified by the lessor as an operating lease. The classification testing is performed prior to considering the proper accounting treatment.

It is a common practice in equipment leasing transactions for the lessor to obtain, from an unrelated third party, a full or partial guarantee of the residual value of a portfolio of leased assets. These transactions are structured in such a manner that the third-party guarantor provides a guarantee of the aggregate residual value of the portfolio but does not individually guarantee the residual value of any of the individually leased assets included in that portfolio. To the extent that a specific leased asset's residual value exceeds the guaranteed minimum amount, that excess is used to offset shortfalls relating to other specific leased assets whose residual values are below the guaranteed minimum amount.

In ASC 840-30-S99, the SEC staff observer announced the SEC staff's position that the expected proceeds from these types of portfolio residual guarantees are to be excluded from minimum lease payments in computing the present value of the minimum lease payments for the purpose of determining the lessor's classification of the lease transaction. The SEC believes this treatment to be appropriate because, under the terms of this portfolio guarantee, the lessor is unable to determine, at lease inception, the guaranteed residual amount of any individually leased asset.

Distinctions among sales-type, direct financing, and leveraged leases.

A lease is classified as a sales-type lease when the criteria set forth above have been met and the lease transaction is structured in such a way that the lessor (generally a manufacturer or dealer) recognizes a profit or loss on the transaction in addition to interest income. In order for this to occur, the fair value of the property must be different from the cost (carrying value). The essential substance of this transaction is that of a sale, and thus its name. Common examples of sales-type leases: (1) when a customer of an automobile dealership opts to lease a car in lieu of an outright purchase, and (2) the re-lease of equipment coming off an expiring lease. Note however, that a lease involving real estate must transfer title (i.e., criterion 1 in the preceding list) by the end of the lease term for the lessor to classify the lease as a sales-type lease.

A direct financing lease differs from a sales-type lease in that the lessor does not realize a profit or loss on the transaction other than interest income. In a direct financing lease, the fair value of the property at the inception of the lease is equal to the cost (carrying value). This type of lease transaction most often involves lessor entities engaged in financing operations. The lessor (a bank, or other financial institution) purchases the asset and then leases the asset to the lessee. This transaction merely replaces the conventional lending transaction in which the borrower uses the borrowed funds to purchase the asset. There are many economic reasons why the lease transaction is considered. They are as follows:

The lessee (borrower) is able to obtain 100% financing
Flexibility of use for the tax benefits
The lessor receives the equivalent of interest as well as an asset with some remaining value at the end of the lease term.

In summary, it may help to visualize the following chart when considering the classification of a lease from the lessor's standpoint:

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One form of a direct financing lease is a leveraged lease which is discussed later in this chapter. This type is mentioned separately because it receives a different accounting treatment by the lessor. A leveraged lease meets all the definitional criteria of a direct financing lease, but differs because it involves at least three parties: a lessee, a long-term creditor, and a lessor (commonly referred to as the equity participant). Other characteristics of a leveraged lease are as follows:

The financing provided by the long-term creditor must be without recourse to the general credit of the lessor, although the creditor may hold recourse with respect to the leased property. The amount of the financing must provide the lessor with substantial “leverage” in the transaction.
The lessor's net investment declines during the early years and rises during the later years of the lease term before its elimination.

Lessee Accounting

As discussed in the preceding section, there are two classifications that apply to a lease transaction from the standpoint of the lessee, operating or capital.

Operating leases.

The accounting treatment accorded an operating lease is relatively simple; the rental payments are charged to expense as the payments are made or become payable. This assumes that the lease payments are being made on a straight-line basis (i.e., an equal payment per period over the lease term).

If the lease agreement calls for either an alternative payment schedule or a scheduled rent increase over the lease term, per ASC 840-20-25, the lease expense is recognized on a straight-line basis over the lease term unless another systematic and rational basis is a better representation of the actual physical usage of the leased property. In addition, the lessor may grant various incentives to the lessee during the lease term, such as a rent holiday, or allowances to fund leasehold improvements. Incentives paid to or incurred on behalf of the lessee by the lessor are an inseparable part of the lease agreement. These amounts are recognized as reductions to rental expense on a straight-line basis over the term of a lease, as described in the preceding paragraph.

In these instances, it is necessary to record either a prepaid asset or a liability depending upon the structure of the payment schedule. If the scheduled increase(s) is due to additional leased property, recognition is to be based on the portion of the leased property that is being utilized with the increased rents recognized over the years that the lessee has control over the use of the additional leased property.

Notice that in the case of an operating lease there is no recognition of the leased asset on the statement of financial position, because the substance of the lease is merely that of a rental. There is no reason to expect that the lessee will derive any future economic benefit from the leased asset beyond the lease term.

Capital leases.

Recall that the classification of a lease is determined prior to the consideration of the accounting treatment. Therefore, it is necessary to first examine the lease transaction against the four criteria (transfer of title, bargain purchase option, 75% of useful life, or 90% of net fair value). Should the lease agreement satisfy one of these, it is accounted for as a capital (also referred to as financing) lease.

The lessee records a capital lease as an asset and an obligation (liability) at an amount equal to the present value of the minimum lease payments at the beginning of the lease term. For the purposes of the 90% test, the present value is computed using the incremental borrowing rate of the lessee unless it is practicable for the lessee to determine the implicit rate used by the lessor, and the implicit rate is less than the incremental borrowing rate. The incremental borrowing rate is defined as the rate at lease inception at which the lessee would have been able to borrow over a loan term equivalent to the lease term had it chosen to purchase the leased asset. If the lessee determines a secured borrowing rate that is reasonable and consistent with the financing that would have been used, then it is acceptable to use a secured borrowing rate.

The asset is recorded at the lower of the present value of the minimum lease payments or the fair value of the asset. When the fair value of the leased asset is less than the present value of the minimum lease payments, the interest rate used to amortize the lease obligation will differ from the interest rate used in the 90% test.

The interest rate used in the amortization will be the same as that used in the 90% test when the fair value is greater than or equal to the present value of the minimum lease payments. For purposes of this computation, the minimum lease payments are considered to be the payments that the lessee is obligated to make or can be required to make excluding executory costs such as insurance, maintenance, and taxes.

The minimum lease payments generally include the minimum rental payments, any guarantee of the residual value made by the lessee, and the penalty for failure to renew the lease, if applicable. If the lease includes a bargain purchase option (BPO), the amount required to be paid under the BPO is also included in the minimum lease payments.

The lease term used in this present value computation is the fixed, noncancelable term of the lease plus the following:

All periods covered by bargain renewal options
All periods for which failure to renew the lease imposes a penalty on the lessee
All periods covered by ordinary renewal options during which the lessee guarantees the lessor's debt on the leased property
All periods covered by ordinary renewals or extensions up to the date a BPO is exercisable
All periods representing renewals or extensions of the lease at the lessor's option.

Remember, if the amount computed as the present value of the minimum lease payments exceeds the fair value of the leased property at the inception of the lease, the amount recorded is limited to the fair value.

The amortization of the leased asset will depend upon how the lease qualifies as a capital lease. If the lease transaction meets the criteria of either transferring ownership, or containing a bargain purchase option, then the asset arising from the transaction is amortized over the estimated useful life of the leased property. If the transaction qualifies as a capital lease because it meets either the 75% of useful life or 90% of fair value criteria, the asset is amortized over the lease term. The conceptual rationale for this differentiated treatment arises because of the substance of the transaction. Under the first two criteria, the asset actually becomes the property of the lessee at the end of the lease term (or upon exercise of the BPO). In the latter situations, the title to the property remains with the lessor, and thus, the lessee ceases to have the right to use the property at the conclusion of the lease term.

The leased asset is amortized (depreciated) over the lease term if title does not transfer to the lessee, while the asset is depreciated in a manner consistent with the lessee's normal depreciation policy if the title is to eventually transfer to the lessee. This latter situation can be interpreted to mean that the asset is depreciated over the useful economic life of the leased asset. The treatment and method used to amortize (depreciate) the leased asset is very similar to that used for any other long-lived asset. The amortization entry requires a debit to amortization expense and a credit to accumulated amortization. The leased asset is not amortized below the estimated residual value.

In some instances when the property is to revert back to the lessor, there may be a guaranteed residual value. This is an amount that the lessee guarantees to the lessor. 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. On the other hand, if the fair value of the leased asset is less than the guaranteed residual value, then the lessee must make up the difference, usually with a cash payment. The guaranteed residual value is often used as a tool to reduce the periodic payments by substituting the lump-sum amount at the end of the term that results from the guarantee. In any event the amortization must still take place based on the estimated residual value. This results in a rational and systematic allocation of the expense to the periods of usage and avoids a large loss (or expense) in the last period as a result of the guarantee.

The annual (periodic) rent payments made during the lease term are allocated between a reduction in the obligation and interest expense in a manner such that the interest expense represents the application of a constant periodic rate of interest to the remaining balance of the lease obligation. This is commonly referred to as the effective interest method.

The following examples illustrate the treatment described in the foregoing paragraphs.

Example of accounting for a capital lease—Asset returned to lessor

The lease is initiated on 1/1/12 for equipment with an expected useful life of three years. The equipment reverts back to the lessor upon expiration of the lease agreement.
The fair value of the equipment at lease inception is $135,000.
Three payments are due to the lessor in the amount of $50,000 per year beginning 12/31/12. An additional sum of $1,000 is to be paid annually by the lessee for insurance.
The lessee guarantees a $10,000 residual value on 12/31/14 to the lessor.
Irrespective of the $10,000 residual value guarantee, the leased asset is expected to have only a $1,000 salvage value on 12/31/14.
The lessee's incremental borrowing rate is 10%. (The lessor's implicit rate is unknown.)
The present value of the lease obligation is as follows:

The first step in dealing with any lease transaction is to classify the lease. In this case, the lease term is for three years, which is equal to 100% of the expected useful life of the asset. Note that the 90% test is also fulfilled as the present value of the minimum lease payments ($131,858) is greater than 90% of the fair value (90% × $135,000 = $121,500). Thus, the lessee accounts for the lease as a capital lease.

In item 7, the present value of the lease obligation is computed. Note that the executory costs (insurance) are not included in the minimum lease payments and that the incremental borrowing rate of the lessee was used to determine the present value. This rate was used because the lessor's implicit rate was not determinable.

NOTE: To have used the implicit rate it would have to have been less than the incremental borrowing rate.

The entry necessary to record the lease on 1/1/12 is

Note that the lease is recorded at the present value of the minimum lease payments that, in this case, is less than the fair value. If the present value of the minimum lease payments had exceeded the fair value, the lease would have been recorded at the fair value.

The next step is to determine the proper allocation between interest and reduction of the lease obligation for each lease payment. This is done using the effective interest method as illustrated below.

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The interest is calculated at 10% (the incremental borrowing rate) of the balance of the lease obligation for each period, and the remainder of each $50,000 payment is allocated as a reduction in the lease obligation. The lessee is also required to pay $1,000 for insurance on an annual basis. The entries necessary to record all payments relative to the lease for each of the three years are shown below.

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The leased equipment recorded as an asset must also be amortized (depreciated). The initial unamortized balance is $131,858; however, as with any other long-lived asset, it cannot be amortized below the estimated residual value of $1,000 (note that it is amortized down to the actual estimated residual value, not the guaranteed residual value). In this case, the straight-line amortization method is applied over a period of three years. This three-year period represents the lease term, not the life of the asset, because the asset reverts back to the lessor at the end of the lease term. Therefore, the following entry will be made at the end of each year:

Finally, on 12/31/14 we must recognize the fact that ownership of the property has reverted back to the owner (lessor). The lessee made a guarantee that the residual value would be $10,000 on 12/31/14; as a result, the lessee must make up the difference between the guaranteed residual value and the actual residual value with a cash payment to the lessor. The following entry illustrates the removal of the leased asset and obligation from the lessee's accounting records:

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The foregoing example illustrated a situation where the asset was to be returned to the lessor. Another situation exists (under BPO or transfer of title) where ownership of the asset is expected to transfer to the lessee at the end of the lease term. Remember that leased assets are amortized over their useful life when title transfers or a bargain purchase option exist. At the end of the lease, the balance of the lease obligation should equal the guaranteed residual value, the bargain purchase option price, or termination penalty for failure to renew the lease.

Example of accounting for a capital lease—Asset ownership transferred to lessee

A three-year lease is initiated on 1/1/12 for equipment with an expected useful life of five years.
Three annual lease payments of $52,000 are required beginning on 1/1/12 (note that the payment at the beginning of the year changes the present value computation from the previous example). The lessee pays $2,000 per year for insurance on the equipment and this amount is included in the annual payments.
The lessee can exercise a bargain purchase option on 12/31/14 for $10,000. The expected residual value at 12/31/14 is $18,000.
The lessee's incremental borrowing rate is 10% (the lessor's implicit rate is unknown).
The fair value of the leased property at the inception of the lease is $140,000.

Once again, the classification of the lease must be determined prior to computing the accounting entries to record it. This lease is classified as a capital lease because it contains a BPO. In this case, the 90% test is also fulfilled.

The present value of the lease obligation is computed as follows:

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Since the lessee pays $2,000 a year for insurance, this payment is treated as executory costs and excluded from the calculation of the present value of the annual payments. Note that the present value of the lease obligation is greater than the fair value of the asset. Because of this, the lease obligation must be recorded at the fair value of the leased asset.

According to ASC 840, the allocation between interest and principal is determined so that interest expense is computed using a constant periodic rate of interest applied to the remaining balance of the obligation. If the fair value of the leased asset is greater than or equal to the present value of the lease obligation, the interest rate used is the same as that used to compute the present value (i.e., the incremental borrowing rate or the implicit rate). In cases such as this, when the present value exceeds the fair value of the leased asset, a new rate must be computed through a series of manual trial and error calculations. Alternatively, spreadsheet or loan amortization software can be used to solve for the unknown effective interest rate. In this situation the interest rate used was 13.267%. The amortization of the lease takes place as follows:

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The following entries are required in years 2012 through 2014 to recognize the payment and amortization.

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Lessor Accounting

As previously noted, there are four classifications of leases with which a lessor must be concerned. They are operating, sales-type, direct financing, and leveraged.

Operating leases.

As in the case of the lessee, the operating lease requires a less complex accounting treatment. The payments received by the lessor are recorded as rent revenues in the period in which the payment is received or becomes receivable. As with the lessee, if the rentals vary from a straight-line basis, the lease agreement contains a scheduled rent increase over the lease term, or the lessor grants incentives to the lessee such as a rent holiday or leasehold improvement allowance, the revenue is recorded on a straight-line basis unless an alternative basis of systematic and rational allocation is more representative of the time pattern of physical usage of the leased property. If the scheduled increase(s) is due to the lessee leasing additional property under a master lease agreement, the increase is allocated proportionally to the additional leased property and recognized on a straight-line basis over the years that the lessee has control over the additional leased property. ASC 840-20-25 prescribes that, in this case, the total revised rent be allocated between the previously leased property and the additional leased property based on their relative fair values.

The lessor presents the leased property on the statement of financial position under the caption “Investment in leased property.” This caption is shown with or near the fixed assets of the lessor, and depreciated in the same manner as the lessor's other fixed assets.

Any initial direct costs are amortized over the lease term as the related lease revenue is recognized (i.e., on a straight-line basis unless another method is more representative). However, these costs may be charged to expense as incurred if the effect is not materially different from straight-line amortization.

Any incentives made by the lessor to the lessee are treated as reductions of rent and recognized on a straight-line basis over the term of the lease.

In most operating leases, the lessor recognizes rental income over the lease term and does not measure or recognize any gain or loss on any differential between the fair value of the property and its carrying value. One exception to this rule is set forth in ASC 840-40. The exception applies when an operating lease involving real estate is not classified as a sales-type lease because ownership to the property does not transfer to the lessee at the end of the lease term. In this case, if at the inception of the lease the fair value of the property is less than its carrying amount, the lessor must recognize a loss equal to that difference at the inception of the lease.

Sales-type leases.

In accounting for a sales-type lease, it is necessary for the lessor to determine the following amounts:

Gross investment
Fair value of the leased asset
Cost.

Note that, following the promulgation of ASC 820, there was some confusion over the definition of fair value to be employed for purposes of lease determination and measurement. ASC 820 does not apply to ASC 840 determinations of lease classifications or measurements. However, ASC 820 is applicable to the determinations to be made in business combinations accounted for under ASC 805.

From these amounts, the remainder of the computations necessary to record and account for the lease transaction can be made. The first objective is to determine the numbers necessary to complete the following entry:

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The gross investment (lease receivable) of the lessor is equal to the sum of the minimum lease payments (excluding executory costs) plus the unguaranteed residual value. The difference between the gross investment and the present value of the two components of gross investment (minimum lease payments and unguaranteed residual value) is recorded as the unearned interest revenue. The present value is computed using the lease term and implicit interest rate (both of which were discussed earlier). The lease term used in this computation includes any renewal options exercisable at the discretion of the lessor. The resulting unearned interest revenue is to be amortized into income using the effective interest method. This will result in a constant periodic rate of return on the net investment (the net investment is the gross investment less the unearned income).

Recall from our earlier discussion that the fair value of the leased property is, by definition, equal to the normal selling price of the asset adjusted by any residual amount retained (this amount retained can be exemplified by an unguaranteed residual value, investment credit, etc.). The adjusted selling price used for a sales-type lease is equal to the present value of the minimum lease payments. Thus, we can say that the normal selling price less the residual amount retained is equal to the PV of the minimum lease payments.

The cost of goods sold to be charged against income in the period of the sale is computed as the historic cost or carrying value of the asset (most likely inventory) plus any initial direct costs, less the present value of the unguaranteed residual value. The difference between the adjusted selling price and the amount computed as the cost of goods sold is the gross profit recognized by the lessor at the inception of the lease (sale). Thus, a sales-type lease generates two types of revenue for the lessor.

The gross profit on the sale
The interest earned on the lease receivable.

Note that if the sales-type lease involves real estate, the lessor must account for the transaction under the provisions of ASC 360 in the same manner as a seller of the same property (see chapter on ASC 360).

The application of these points is illustrated in the example below.

Example of accounting for a sales-type lease

Price Inc. is a manufacturer of specialized equipment. Many of its customers do not have the necessary funds or financing available for outright purchase. Because of this, Price offers a leasing alternative. The data relative to a typical lease are as follows:

The noncancelable fixed portion of the lease term is five years. The lessor has the option to renew the lease for an additional three years at the same rental. The estimated useful life of the asset is ten years.
The lessor is to receive equal annual payments over the term of the lease. The leased property reverts back to the lessor upon termination of the lease.
The lease is initiated on 1/1/12. Payments are due annually on 12/31 for the duration of the lease term.
The cost of the equipment to Price Inc. is $100,000. The lessor incurs costs associated with the inception of the lease in the amount of $2,500.
The selling price of the equipment for an outright purchase is $150,000.
The equipment is expected to have a residual value of $15,000 at the end of five years and $10,000 at the end of eight years.
The lessor desires a return of 12% (the implicit rate).

The first step is to calculate the annual payment due to the lessor. To yield the lessor's desired return, the present value of the minimum lease payments must equal the selling price adjusted for the present value of the residual amount. The present value is computed using the implicit interest rate and the lease term. In this case, the implicit rate is given as 12% and the lease term is eight years (the fixed noncancelable portion plus the renewal period). Thus, the computation would be as follows:

Or, in this case,

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Prior to examining the accounting implications of the lease, we must first determine the lease classification. Assume that there are no uncertainties regarding the lessor's costs, and the collectibility of the lease payments is reasonably assured. In this example, the lease term is eight years (discussed above) while the estimated useful life of the asset is ten years; thus, this lease is not an operating lease because the lease term covers 80% of the asset's estimated useful life. This exceeds the previously discussed 75% criterion. (Note that it also meets the 90% of fair value criterion because the present value of the minimum lease payments of $145,961.20 is greater than 90% of the fair value [90% × $150,000 = $135,000]). Next it must be determined if this is a sales-type, direct financing, or leveraged lease. To do this, examine the fair value or selling price of the asset and compare it to the cost. Because the two are not equal, this is a sales-type lease.

Next, obtain the figures necessary for the lessor to record the entry. The gross investment is the total minimum lease payments plus the unguaranteed residual value, or:

The cost of goods sold is the historical cost of the inventory ($100,000) plus any initial direct costs ($2,500) less the present value of the unguaranteed residual value ($10,000 × .40388 = $4,038.80). Thus, the cost of goods sold amount is $98,461.20 (= $100,000 + $2,500 − $4,038.80).

Note that the initial direct costs will require a credit entry to record their accrual (accounts payable) or payment (cash). The inventory account is credited for the carrying value of the asset, in this case $100,000.

The adjusted selling price is equal to the present value of the minimum payments, or $145,961.20. Finally, the unearned interest revenue is equal to the gross investment (i.e., lease receivable) less the present value of the components making up the gross investment (the present values of the minimum annual lease payments of $29,382.40 and the unguaranteed residual of $10,000). The computation is [$245,059.20 − ($29,382.40 × 4.96764 = $145,961.20) − ($10,000 × .40388 = 4,038.80) = $95,059.20]. Therefore, the entry necessary for the lessor to record the lease is:

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The next step in accounting for a sales-type lease is to determine the proper handling of each payment. Both principal and interest are included in each payment. Interest is recognized using the effective interest rate method so that an equal rate of return is earned each period over the term of the lease. This will require setting up an amortization schedule, as illustrated below.

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A few of the columns need to be elaborated upon. First, the net investment is the gross investment (lease receivable) less the unearned interest. Note that at the end of the lease term, the net investment is equal to the estimated residual value. Also note that the total interest earned over the lease term is equal to the unearned interest at the beginning of the lease term.

The entries below illustrate the proper accounting for the receipt of the lease payment and the amortization of the unearned interest in the first year.

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Note that there is no entry to recognize the principal reduction. This is done automatically when the net investment is reduced by decreasing the lease receivable (gross investment) by $29,382.40 and the unearned interest account by only $18,000. The $18,000 is 12% (implicit rate) of the net investment. These entries are to be made over the life of the lease.

At the end of the lease term the asset is returned to the lessor and the following entry is required:

Direct financing leases.

The accounting for a direct financing lease holds many similarities to that for a sales-type lease. Of particular importance is that the terminology used is much the same; however, the treatment accorded these items varies greatly. Again, it is best to preface our discussion by determining our objectives in the accounting for a direct financing lease. Once the lease has been classified, it must be recorded. To do this, the following numbers must be obtained:

Gross investment
Cost
Residual value.

As noted, a direct financing lease generally involves a leasing company or other financial institution and results in only interest income being earned by the lessor. This is because the fair value (selling price) and the cost are equal and, therefore, no profit is recognized on the actual lease transaction. Note how this is different from a sales-type lease that involves both a profit on the transaction and interest income over the lease term. The reason for this difference is derived from the conceptual nature underlying the purpose of the lease transaction. In a sales-type lease, the manufacturer (distributor, dealer) is seeking an alternative means to finance the sale of the product, whereas a direct financing lease is a result of the consumer's need to finance an equipment purchase through a third party. Because the consumer is unable to obtain conventional financing, he or she turns to a leasing company that will purchase the desired asset and then lease it to the consumer. Here the profit on the transaction remains with the manufacturer, while the interest income is earned by the leasing company.

Like a sales-type lease, the first objective is to determine the amounts necessary to complete the following entry:

The gross investment is still defined as the minimum amount of lease payments exclusive of any executory costs plus the unguaranteed residual value. The difference between the gross investment as determined above and the cost (carrying value) of the asset is to be recorded as the unearned interest income because there is no manufacturer's/dealer's profit earned on the transaction. The following entry would be made to record the initial direct costs:

The net investment in the lease is defined as the gross investment less the unearned interest income plus the unamortized initial direct costs related to the lease. Initial direct costs are defined in the same way that they were for purposes of the sales-type lease; however, the accounting treatment is different. For a direct financing lease, the unearned lease (interest) income and the initial direct costs are amortized to income over the lease term to yield a constant effective rate of interest on the net investment. Thus, the effect of the initial direct costs is to reduce the implicit interest rate, or yield, to the lessor over the life of the lease.

An example follows that illustrates the preceding principles.

Example of accounting for a direct financing lease

Edwards, Inc. needs new equipment to expand its manufacturing operation; however, it does not have sufficient capital to purchase the asset at this time. Because of this, Edwards has employed Samuels Leasing to purchase the asset. In turn, Edwards (the lessee) will lease the asset from Samuels (the lessor). The following information applies to the terms of the lease:

Lease information

A three-year lease is initiated on 1/1/12 for equipment costing $131,858 with an expected useful life of five years. Fair value at 1/1/12 of the equipment is $131,858.
Three annual payments are due to the lessor beginning 12/31/12. The property reverts back to the lessor upon termination of the lease.
The unguaranteed residual value at the end of year three is estimated to be $10,000.
The annual payments are calculated to give the lessor a 10% return (implicit rate).
The lease payments and unguaranteed residual value have a present value equal to $131,858 (FMV of asset) at the stipulated discount rate.
The annual payment to the lessor is computed as follows:
Initial direct costs of $7,500 are incurred by Samuels in the lease transaction.

As with any lease transaction, the first step must be to determine the proper classification of the lease. In this case, the present value of the lease payments ($124,345) exceeds 90% of the fair value (90% × $131,858 = $118,672). Assume that the lease payments are reasonably assured and that there are no uncertainties surrounding the costs yet to be incurred by the lessor.

Next, determine the unearned interest and the net investment in the lease.

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The unamortized initial direct costs are to be added to the gross investment in the lease and the unearned interest income is to be deducted to arrive at the net investment in the lease. The net investment in the lease for this example is determined as follows:

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The net investment in the lease (Gross investment − Unearned revenue) has been increased by the amount of initial direct costs. Therefore, the implicit rate is no longer 10%. We must recompute the implicit rate. The implicit rate is really the result of an internal rate of return calculation. We know that the lease payments are to be $50,000 per annum and that a residual value of $10,000 is expected at the end of the lease term. In return for these payments (inflows) we are giving up equipment (outflow) and incurring initial direct costs (outflows) with a net investment of $139,358 ($131,858 + $7,500). The only way to manually obtain the new implicit rate is through a trial and error calculation, as set up below.

Where i = implicit rate of interest

This computation is most efficiently performed using either spreadsheet or present value software. In doing so, the $139,358 is entered as the present value, the contractual payment stream and residual value are entered, and the software iteratively solves for the unknown implicit interest rate.

In this case, the implicit rate is equal to 7.008%. Thus, the amortization table would be set up as follows:

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Here the interest is computed as 7.008% of the net investment. Note again that the net investment at the end of the lease term is equal to the estimated residual value.

The entry made to initially record the lease is as follows:

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When the payment of (or obligation to pay) the initial direct costs occurs, the following entry must be made:

Using the schedule above, the following entries would be made during each of the indicated years:

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Finally, when the asset is returned to the lessor at the end of the lease term, it must be recorded by the following entry:

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Leveraged leases.

One of the more complex accounting subjects regarding leases is the accounting for a leveraged lease. Just as is the case with sales-type and direct financing leases, the classification of the lease by the lessor has no impact on the classification of the lease by the lessee. The lessee simply considers whether the lease qualifies as an operating lease or a capital lease. The lessor's accounting issues, however, are substantially more complex.

To qualify as a leveraged lease, a lease agreement must meet the following requirements, and the lessor must account for the investment tax credit (when in effect) in the manner described below.

NOTE: Failure to do so will result in the lease being classified as a direct financing lease.

The lease must meet the definition of a direct financing lease (the 90% of fair value criterion does not apply).¹
The lease must involve at least three parties.
1. An owner-lessor (equity participant)
2. A lessee
3. A long-term creditor (debt participant)
The financing provided by the creditor is nonrecourse as to the general credit of the lessor and is sufficient to provide the lessor with substantial leverage.
The lessor's net investment (defined below) decreases in the early years and increases in the later years until it is eliminated.

This last characteristic poses the accounting issue.

The leveraged lease arose as a result of an effort to maximize the income tax benefits associated with a lease transaction. To accomplish this, it was necessary to involve a third party to the lease transaction (in addition to the lessor and lessee): a long-term creditor. The following diagram² illustrates the relationships in a leveraged lease agreement:

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The owner-lessor obtains long-term financing from the creditor, generally in excess of 50% of the purchase price. ASC 840 indicates that the lessor must be provided with sufficient leverage in the transaction, therefore the 50%.
The owner then uses this financing along with his/her own funds to purchase the asset from the manufacturer.
The manufacturer delivers the asset to the lessee.
The lessee remits the periodic rent to the lessor.
The debt is guaranteed by either using the equipment as collateral, the assignment of the lease payments, or both, depending on the demands established by the creditor.

The FASB concluded that the entire lease agreement be accounted for as a single transaction and not a direct financing lease plus a debt transaction. The feeling was that the latter did not readily convey the lessor's net investment in the lease to the user of the financial statements. Thus, the lessor records the investment as a net amount. The gross investment is calculated as a combination of the following amounts:

The rentals receivable from the lessee, net of the principal and interest payments due to the long-term creditor
A receivable for the amount of the investment tax credit (ITC) to be realized on the transaction³
The estimated residual value of the leased asset
The unearned and deferred income, consisting of:
1. The estimated pretax lease income (or loss), after deducting initial direct costs, remaining to be allocated to income
2. The ITC remaining to be allocated to income over the remaining term of the lease³.

The first three amounts described above are readily obtainable; however, the last amount, the unearned and deferred income, requires additional computations. In order to compute this amount, it is necessary to create a cash flow (income) analysis by year for the entire lease term. As described in item 4 of the preceding list, the unearned and deferred income consists of the pretax lease income (Gross lease rentals − Depreciation − Loan interest) and the unamortized investment tax credit. The total of these two amounts for all of the periods in the lease term represents the unearned and deferred income at the inception of the lease.

The amount computed as the gross investment in the lease (foregoing paragraphs) less the deferred taxes relative to the difference between pretax lease income and taxable lease income is the net investment for purposes of computing the net income for the period. To compute the periodic net income, another schedule must be completed that uses the cash flows derived in the first schedule and allocates them between income and a reduction in the net investment.

The amount of income is first determined by applying a rate to the net investment. The rate to be used is the rate that will allocate the entire amount of cash flow (income) when applied in the years in which the net investment is positive. In other words, the rate is derived in much the same way as the implicit rate (trial and error), except that only the years in which there is a positive net investment are considered. Thus, income is recognized only in the years in which there is a positive net investment.

The income recognized is divided among the following three elements:

Pretax accounting income
Amortization of investment tax credit
The tax effect of the pretax accounting income.

The first two are allocated in proportionate amounts from the unearned and deferred income included in the calculation of the net investment. In other words, the unearned and deferred income consists of pretax lease accounting income and ITC. Each of these is recognized during the period in the proportion that the current period's allocated income is to the total income (cash flow). The last item, the income tax effect, is recognized in income tax expense for the year. The income tax effect of any difference between pretax lease accounting income and taxable lease income is charged (or credited) to deferred income taxes.

When income tax rates change, all components of a leveraged lease must be recalculated from the inception of the lease using the revised after-tax cash flows arising from the revised income tax rates.

If, in any case, the projected cash receipts (income) are less than the initial investment, the deficiency is to be recognized as a loss at the inception of the lease. Similarly, if at any time during the lease period the aforementioned method of recognizing income would result in a future period loss, the loss is to be recognized immediately.

This situation may arise as a result of the circumstances surrounding the lease changing. Therefore, any estimated residual value and other important assumptions must be reviewed on a periodic basis (at least annually). Any change is to be incorporated into the income computations; however, there is to be no upward revision of the estimated residual value.

The following example illustrates the application of these principles to a leveraged lease.

Example of simplified leveraged lease

A lessor acquires an asset for $100,000 with an estimated useful life of three years in exchange for a $25,000 down payment and a $75,000 three-year note with equal payments due on 12/31 each year. The interest rate is 18%.
The asset has no residual value.
The present value of an ordinary annuity of $1 for three years at 18% is 2.17427.
The asset is leased for three years with annual payments due to the lessor on 12/31 in the amount of $45,000.
The lessor uses the Accelerated Cost Recovery System (ACRS) method of depreciation (150% declining balance with a half-year convention in the year placed in service) for income tax purposes and elects to reduce the ITC rate to 4% as opposed to reducing the depreciable basis.
Assume a constant income tax rate throughout the life of the lease of 40%.

Chart 1 analyzes the cash flows generated by the leveraged leasing activities. Chart 2 allocates the cash flows between the investment in leveraged leased assets and income from leveraged leasing activities. The allocation requires finding that rate of return, which when applied to the investment balance at the beginning of each year that the investment amount is positive, will allocate the net cash flow fully to net income over the term of the lease. This rate can be found only by a computer program or by an iterative trial and error process. The example that follows has a positive investment value in each of the three years, and thus the allocation takes place in each time period. Leveraged leases usually have periods where the investment account turns negative and is below zero.

Allocating principal and interest on the loan payments is as follows:

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Chart 1

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The chart below allocates the cash flows determined above between the net investment in the lease and income. Recall that the income is then allocated between pretax accounting income and the amortization of the investment credit. The income tax expense for the period is a result of applying the income tax rate to the current periodic pretax accounting income.

The amount to be allocated in total in each period is the net cash flow determined in column H above. The investment at the beginning of year one is the initial down payment of $25,000. This investment is then reduced on an annual basis by the amount of the cash flow not allocated to income.

Chart 2

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Column 2 is the net cash flow after the initial investment, and columns 3 and 4 are the allocation based upon the 15.77% rate of return. The total of column 4 is the same as the total of column H in Chart 1.
Column 5 allocates column D in Chart 1 based upon the allocations in column 4. Column 6 allocates column E in Chart 1, (and, of course, is computed as 40% of column 5) and column 7 allocates column G in Chart 1 on the same basis.

The journal entries below illustrate the proper recording and accounting for the leveraged lease transaction. The initial entry represents the cash down payment, investment tax credit receivable, the unearned and deferred revenue, and the net cash to be received over the term of the lease.

The remaining journal entries recognize the annual transactions which include the net receipt of cash and the amortization of income.

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The following schedules illustrate the computation of deferred income tax amount. The annual amount is a result of the temporary difference created due to the difference in the timing of the recognition of income for GAAP and income tax purposes. The income for income tax purposes can be found in column D in Chart 1, while the income for GAAP purposes is found in column 5 of Chart 2. The actual amount of deferred income tax is the difference between the income tax computed with the temporary difference and the income tax computed without the temporary difference. These amounts are represented by the income tax payable or receivable as shown in column E of Chart 1 and the income tax expense as shown in column 6 of Chart 2. A check of this figure is provided by multiplying the difference between GAAP income and tax income by the annual rate.

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Interpretive guidance.

Changes in income tax rates. ASC 840 requires that the rate of return and allocation of income to be recalculated from the date of inception of a lease and a gain or loss recognized when an important assumption is changed. Per ASC 840-30-35, the effect on a leveraged lease of a change in the income tax rate is recognized as a gain or loss in the accounting period in which the rate changes. Deferred income taxes relating to the change are recognized in accordance with ASC 740.

Change or projected changes in the timing of cash flows relative to income taxes applicable to a leveraged lease transaction. ASC 840 also provides that the projected timing of income tax cash flows attributable to a leveraged lease is to be reviewed annually during the lease term (or between annual reviews if events or changes in circumstances indicate that a change in timing either has occurred or is projected to occur in the future). Upon review, if the projected timing of the lease's income tax cash flows changes, the lessor will be required to recalculate, from the inception of the lease, the rate of return and the allocation of income to positive investment years in accordance with ASC 840-30-35. The net investment amount is adjusted to the recalculated amount with the change recognized as a gain or loss in the year that the assumptions changed. The pretax gain or loss is to be included in income from continuing operations before income taxes in the same financial statement caption in which leverage lease income is recognized with the income tax effect of the gain or loss reflected in the income tax provision or benefit.

The standard further provides that the recalculated cash flows are to exclude interest and penalties, advance payments, and deposits to the IRS (and presumably any other relevant state, local, or foreign taxing jurisdiction). The deposits or advance payments are to be included in the projected amount of the settlement with the taxing authority.

This accounting treatment is applicable only to changes or projected changes in the timing of income taxes that are directly attributable to the leveraged lease transaction. ASC 840-30-35 provides that reporting entities whose tax positions frequently vary between the alternative minimum tax (AMT) and regular tax are not required to annually recalculate the net investment in the lease unless there is an indication that the original assumptions about the leveraged lease's anticipated total after-tax net income were no longer valid.

Another factor to consider in the determination of the after-tax cash flows attributable to a leveraged lease transaction is the application of ASC 740-40-25, Income Taxes—Recognition. As discussed in detail in the chapter on ASC 740, the lessor is required to assess whether it is more likely than not (i.e., there is a greater than 50% chance probability) that the tax positions it takes or plans to take relative to the transaction would be sustained upon examination by the applicable taxing authorities. If the tax positions do not meet that recognition threshold, the tax benefits associated with taking those positions would be excluded from the leveraged lease calculations and, in fact, would give rise to a liability for unrecognized income tax benefits as well as an accrual for any applicable interest and penalties for all open tax years that are within the statute of limitations. This could obviously have a significant impact on the computed rate of return on the investment attributable to the years in which the net investment is positive.

If, however, the tax positions meet the recognition threshold, then they are subject to measurement to determine the maximum amount that is more than 50% probable of being sustained upon examination. The difference between the income tax position taken or planned to be taken on the income tax return (the “as-filed” benefit), and the amount of the benefit measured using the more than 50% computation, along with any associated penalties and interest, is recorded as the liability for unrecognized income tax benefits as previously described.

The only situation in which this liability, penalties, and interest would not be applicable would be if the tax positions were assessed to be highly certain tax positions, as defined in ASC 740-10-55. Under those circumstances, the entire tax benefit associated with the lease would be recognized and, of course, no interest or penalties would be recognized.

Applicability to real estate leases. The foregoing discussion involved the lease of a manufactured asset. ASC 840-40 clarifies that leases that involve land and buildings or leases in a sale-leaseback transaction potentially qualify as leveraged leases if the criteria to qualify as a leveraged lease are met.

Applicability to existing assets of the lessor. At the inception of a lease, the cost or carrying value and the fair value of an asset must be the same for the lease to be classified as a direct financing lease which is a necessary condition for leveraged lease treatment. The carrying amount of an existing asset before any write-down must equal its fair value in order for the lease to be classified as a leveraged lease (ASC 840-10-55).

Real Estate Leases

Real estate leases can be divided into the following four categories:

Leases involving land only
Leases involving land and building(s)
Leases involving real estate and equipment
Leases involving only part of a building.

Leases involving only land.

Lessee accounting. If the lease agreement transfers ownership or contains a bargain purchase option, the lessee accounts for the lease as a capital lease, and records an asset and related liability equal to the present value of the minimum lease payments. If the lease agreement does not transfer ownership or contain a bargain purchase option, the lessee accounts for the lease as an operating lease.

Lessor accounting. If the lease gives rise to dealer's profit (or loss) and transfers ownership (i.e., title), the lease is classified as a sales-type lease and accounted for under the provisions of ASC 360-20 in the same manner as a seller of the same property. If the lease transfers ownership and the criteria for both collectibility and no material uncertainties are met, but the lease does not give rise to dealer's profit (or loss), the lease is accounted for as a direct financing or leveraged lease as appropriate. If the lease does not transfer ownership, but it contains a bargain purchase option and both the collectibility and no material uncertainties criteria are met, the lease is accounted for as a direct financing, leveraged, or operating lease using the same lessor classification criteria as any other lease. If the lease does not meet the collectibility and/or no material uncertainties criteria, the lease is accounted for as an operating lease.

Leases involving land and building.

Lessee accounting. If the agreement transfers title or contains a bargain purchase option, the lessee accounts for the agreement by separating the land and building components and capitalizing each separately. The land and building elements are allocated on the basis of their relative fair values measured at the inception of the lease. The land and building components are separately accounted for because the lessee is expected to own the real estate by the end of the lease term. The building is amortized over its estimated useful life without regard to the lease term.

When the lease agreement neither transfers title nor contains a bargain purchase option, the fair value of the land must be determined in relation to the fair value of the aggregate property included in the lease agreement. If the fair value of the land is less than 25% of the aggregate fair value of the leased property, then the land is considered immaterial. Conversely, if the fair value of the land is 25% or greater of the fair value of the aggregate leased property, then the land is considered material and the land and building must be treated separately for accounting purposes.

When the land component of the lease agreement is considered immaterial (fair value land < 25% of the total fair value), the lease is accounted for as a single unit. The lessee capitalizes the lease if one of the following applies:

The term of the lease is 75% or more of the economic useful life of the building.
The present value of the minimum lease payments equals 90% or more of the fair value of the leased real estate less any lessor investment tax credit.

If neither of the above two criteria is met, the lessee accounts for the lease agreement as a single operating lease.

When the land component of the lease agreement is considered material (fair value land ≥ 25% of the total fair value), the land and building components are separated. By applying the lessee's incremental borrowing rate to the fair value of the land, the annual minimum lease payment attributed to land is computed. The remaining payments are attributed to the building. The division of minimum lease payments between land and building is essential for both the lessee and lessor. The portion of the lease involving the land is always accounted for as an operating lease. The lease involving the building(s) must meet either the 75% or 90% test to be treated as a capital lease. If neither of the two criteria is met, the building(s) are also accounted for as an operating lease.

Computing the minimum lease payments.

Construction period lease payments. Payments made by a lessee during construction of the leased asset and prior to the beginning of the lease term (sometimes called “construction period lease payments”) are considered part of the minimum lease payments for the purpose of the 90% of fair value test. These advance payments are to be included in minimum lease payments at their future value, at the beginning of the lease term, with interest accreted using the same interest rate used to discount payments made during the lease term (ASC 840-10-25).

If the lease is an operating lease, these payments are accounted for as prepaid rent and amortized to expense along with other rental costs over the term of the lease, normally using the straight-line method.

Residual value guarantees. If the terms of the lease include a guarantee of the residual value of the leased property by the lessee, that guarantee is to be included in the minimum lease payments and, in accordance with ASC 840-10-25, is to be allocated entirely to the building. This treatment is consistently followed by both the lessee and the lessor.

Environmental indemnifications. An indemnification by the lessee to the lessor that any environmental contamination that the lessee causes during the lease term does not affect the lessee's classification of the lease as capital or operating.

If the lessee's indemnification covers contamination that occurred prior to the lease term, the lessee is to consider, under the ASC 450 criteria for evaluating contingencies, whether the likelihood of loss is considered remote, reasonably possible, or probable before considering any available reimbursements available from insurance companies or other third parties. If the probability of loss is considered remote, then the indemnification does not affect the lessee's classification of the lease. If, however, the probability of loss is either reasonably possible or probable, the transaction is subject to the sale-leaseback provisions of ASC 840-40 and the lessee will be considered to have purchased, sold, and then leased back the property. A lessee providing an indemnification that meets certain criteria under ASC 460 is required to record the indemnification as a guarantee and, in addition, is subject to that pronouncement's disclosure provisions.

Lessee obligation to maintain financial covenants. Leases sometimes contain financial covenants similar to those included in loan agreements that obligate the lessee to maintain certain financial ratios. Should the lessee violate these covenants, it is considered an event of default under the lease and the lessor may have a right to put the property to the lessee or require the lessee to make a payment to the lessor. In this case, for the purpose of the 90% of fair value test, the lessee includes in the minimum lease payments the maximum amount it would be required to pay in the event of default unless all of the following conditions exist:

The default covenant provision is customary in financing arrangements,
The occurrence of the event of default is objectively determinable and is not at the subjective whim of the lessor,
The event of default is based on predefined criteria that relate solely to the lessee and its operations, and
It is reasonable to assume at the inception of the lease and in considering recent lessee operating trends that the event of default will not occur.

Lessor accounting. The lessor's accounting depends on whether the lease transfers ownership, contains a bargain purchase option, or does neither of the two.

If the lease transfers ownership and gives rise to dealer's profit (or loss), the lessor classifies the lease as a sales-type lease and accounts for the lease as a single unit under the provisions of ASC 360-20 in the same manner as a seller of the same property. If the lease transfers ownership, meets both the collectibility and no important uncertainties criteria, but does not give rise to dealer's profit (or loss), the lease is accounted for as a direct financing or leveraged lease as appropriate.

If the lease contains a bargain purchase option and gives rise to dealer's profit (or loss), the lease is classified as an operating lease. If the lease contains a bargain purchase option, meets both the collectibility and no material uncertainties criteria, but does not give rise to dealer's profit (or loss), the lease is accounted for as a direct financing lease or a leveraged lease as appropriate.

If the lease agreement neither transfers ownership nor contains a bargain purchase option, the lessor should follow the same rules as the lessee in accounting for real estate leases involving land and building(s).

However, the collectibility and the no material uncertainties criteria must be met before the lessor can account for the agreement as a direct financing lease, and in no such case may the lease be classified as a sales-type lease (i.e., ownership must be transferred).

The treatment of a lease involving both land and building can be illustrated in the following examples.

Example of lessee accounting for land and building lease containing transfer of title

The lessee enters into a ten-year noncancelable lease for a parcel of land and a building for use in its operations. The building has an estimated remaining useful life of twelve years.
The fair value of the land is $75,000, while the fair value of the building is $310,000.
A payment of $50,000 is due to the lessor at the beginning of each of the ten years of the lease.
The lessee's incremental borrowing rate is 10%. (The lessor's implicit rate is unknown.)
Ownership will transfer to the lessee at the end of the lease.

The present value of the minimum lease payments is $337,951 ($50,000 × 6.75902)⁴. The portion of the present value of the minimum lease payments to be capitalized for each of the two components of the lease is computed as follows:

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Subsequently, the obligation will be decreased using the effective interest method. The leased building will be amortized over its expected useful life.

Example of lessee accounting for land and building lease without transfer of title or bargain purchase option

Assume the same facts as the previous example except that title does not transfer at the end of the lease.

The lease is still a capital lease because the lease term is more than 75% of the remaining useful life of the building. Since the fair value of the land is less than 25% of the aggregate fair value of the leased property, (75,000/385,000 = 19%), the land component is considered immaterial and the lease is accounted for as a single unit. The entry to record the lease is as follows:

Assume the same facts as the previous example except that the fair value of the land is $110,000 and the fair value of the building is $275,000. Once again title does not transfer.

Because the fair value of the land exceeds 25% of the aggregate fair value of the leased property (110,000/385,000 = 29%), the land component is considered material and the lease is separated into two components. The annual minimum lease payment attributed to the land is computed as follows:

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The remaining portion of the annual payment is attributed to the building.

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The present value of the minimum annual lease payments attributed to the building is then computed as follows:

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The entry to record the capital portion of the lease is as follows:

There is no computation of the present value of the minimum annual lease payment attributed to the land since the land component of the lease is treated as an operating lease. For this reason, each year $16,275 of the $50,000 lease payment will be recorded as land rental expense. The remainder of the annual payment ($33,725) will be applied against the lease obligation using the effective interest method.

Leases involving real estate and equipment.

ASC 360-20-15 states that sales of integral equipment are within the scope of ASC 360-20. Consequently, the determination of whether equipment is considered to be integral equipment has increased in importance. A determination of whether equipment to be leased is integral is also necessary for proper accounting for sales-type leases by lessors.

According to ASC 360-20-15, the determination of whether equipment is integral is based on two factors.

The significance of the cost to remove the equipment from its existing location (which would include the costs of repairing the damage done to that location by the removal).
The decrease in value of the equipment that would result from its removal (which is, at minimum, the cost to ship the equipment to the new site and reinstall it). The nature of the equipment and whether others can use it are considered in determining whether there is further diminution in fair value. When the combined total of the cost to remove and any further diminution of value exceeds 10% of the fair value of the equipment (installed), the equipment is considered integral equipment.

ASC 360-20-15 clarifies that ASC 360-20 applies to all sales of real estate, including real estate with accompanying property improvements or integral equipment. Consistent with ASC 360-20-15, ASC 840-10-25 specifies that when evaluating a lease that includes integral equipment to determine the classification of the lease under ASC 840, the equipment is to be evaluated as real estate. ASC 840-10-25 also provides guidance on evaluating how to determine transfer of ownership of integral equipment when no statutory title registration system exists in the jurisdiction.

When real estate leases also involve equipment or machinery, the equipment component is separated and accounted for as a separate lease agreement by both lessees and lessors. “The portion of the minimum lease payments applicable to the equipment element of the lease shall be estimated by whatever means are appropriate in the circumstances.” The lessee and lessor apply the capitalization requirements to the equipment lease independently of accounting for the real estate lease(s). The real estate leases are handled as discussed in the preceding two sections. In a sale-leaseback transaction involving real estate with equipment, the equipment and land are not separated.

Leases involving only part of a building.

It is common to find lease agreements that involve only part of a building as, for example, when leasing a floor of an office building or a store in a shopping mall. A difficulty that arises in this situation is that the cost and/or fair value of the leased portion of the whole may not be objectively determinable.

Lessee accounting. If the fair value of the leased property is objectively determinable, then the lessee follows the rules and accounts for the lease as described in “Leases involving land and building.” If the fair value of the leased property cannot be objectively determined, consider whether the agreement satisfies the 75% test. This calculation is made using the estimated remaining economic life of the building in which the leased premises are located. If the test is met (i.e. the term of the lease is 75% or more of the estimated remaining economic life of the building), the lease is accounted for as a capital lease. If the test is not met, the lease is accounted for as an operating lease.

Lessor accounting. From the lessor's position, both the cost and fair value of the leased property must be objectively determinable before the procedures described under “Leases involving land and building” will apply. If either the cost or the fair value cannot be determined objectively, the lessor accounts for the agreement as an operating lease.

Operating leases with guarantees.

It is important to note that, for any operating lease where the terms include a guarantee of the residual value of the leased asset, two issues require consideration:

Since a guarantee constitutes a variable interest in the lessor or in the leased assets, does the guarantee cause the lessee to be the primary beneficiary of the lessor that would be required to consolidate the lessor? (See discussion of ASC 810 earlier in this chapter.)
Is the guarantee required to be recognized as a liability at inception on the statement of financial position of the lessee under ASC 460?

Lessee-incurred real estate development or construction costs.

Lessees sometimes incur real estate development or construction costs prior to executing a lease with the developer/lessor. The lessee records these costs as construction in progress on its statement of financial position and any subsequent lease arrangement is accounted for as a sale-leaseback transaction under ASC 840-40, as discussed in the following section.

Sale-Leaseback Transactions

Sale-leaseback describes a transaction where the owner of property (seller-lessee) sells the property, and then immediately leases all or part of it back from the new owner (buyer-lessor). These transactions may occur when the seller-lessee is experiencing cash flow or financing problems or because of available income tax advantages. The important consideration in this type of transaction is the recognition of two separate and distinct economic events. It is important to note, however, that in a typical sale-leaseback there is not a change in the party that has the right to use the property. First, there is a sale of property, and second, there is a lease agreement for the same property in which the original seller is the lessee and the original buyer is the lessor. This is illustrated below.

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A sale-leaseback transaction is usually structured with the sales price of the asset at or above its current fair value. The result of this higher sales price is higher periodic rental payments over the lease term. The transaction is usually attractive because of the income tax benefits associated with it. The seller-lessee benefits from the higher price because of the increased gain on the sale of the property and the deductibility of the lease payments that are usually larger than the depreciation that was previously being deducted. The buyer-lessor benefits from both the higher rental payments and the larger depreciable income tax basis.

Retention of rights to use the property.

The accounting treatment from the seller-lessee's point of view will depend upon the extent to which it retains the rights to use the property which can be characterized as one of the following:

Substantially all
Minor
More than minor but less than substantially all.

Retention of Rights to Use Property

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Present value of reasonable leaseback rentals as a percent of the fair value of the asset sold

As depicted in the diagram “Retention of Rights to Use Property,” the guideline for the determination of substantially all is based upon the classification criteria presented for the lease transaction. That is, if the present value of fair rental payments is equal to 90% or more of the fair value of the asset sold, the seller-lessee is presumed to have retained substantially all of the rights to use the sold property. The test for retention of minor rights would be to substitute 10% or less for 90% or more in the preceding sentence.

If substantially all the rights to use the property are retained by the seller-lessee, and the agreement meets at least one of the criteria for capital lease treatment, the seller-lessee accounts for the leaseback as a capital lease and any profit on the sale is deferred and amortized in proportion to amortization of the leased asset. If the leaseback is classified as an operating lease, it is accounted for as such, and any profit on the sale is deferred and amortized over the lease term in proportion to gross rental charges. Any loss on the sale would also be deferred unless the loss were perceived to be a real economic loss, in which case the loss would be immediately recognized and not deferred.

If only a minor portion of the rights to use are retained by the seller-lessee, the sale and the leaseback are accounted for separately. However, if the rental payments appear unreasonable based upon the existing market conditions at the inception of the lease, the profit or loss is adjusted so the rentals are at a reasonable amount. The amount created by the adjustment is deferred and amortized over the life of the property if a capital lease is involved or over the lease term if an operating lease is involved.

If the seller-lessee retains more than a minor portion but less than substantially all the rights to use the property, any excess profit on the sale is recognized on the date of the sale. For purposes of this paragraph, excess profit is derived as follows:

If the leaseback is classified as an operating lease, the excess profit is the portion of the profit that exceeds the present value of the minimum lease payments over the lease term including the gross amount of the guaranteed residual value. The seller-lessee uses its incremental borrowing rate to compute the present value of the minimum lease payments. If the implicit rate of interest in the lease is known and lower, it is substituted for the incremental borrowing rate in computing the present value of the minimum lease payments. The present value is amortized over the lease term while that guaranteed residual is deferred until resolution at the end of the lease term.
If the leaseback is classified as a capital lease, the excess profit is the portion of the profit that exceeds the recorded amount of the leased asset.

Executory costs are not to be included in the calculation of profit to be deferred in a sale-leaseback transaction (ASC 840-40-30). When the fair value of the property at the time of the leaseback is less than its undepreciated cost, the seller-lessee immediately recognizes a loss for the difference. In the example below, the sales price is less than the book value of the property. However, there is no economic loss because the fair value is greater than the book value.

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The artificial loss is deferred and amortized as an addition to depreciation.

The diagram below summarizes the accounting for sale-leaseback transactions.

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In the above circumstances, when the leased asset is land only, any amortization is recognized on a straight-line basis over the lease term, regardless of whether the lease is classified as a capital or operating lease.

The buyer-lessor accounts for the transaction as a purchase and a direct financing lease if the agreement meets the criteria of either a direct financing lease or a sales-type lease. Otherwise, the agreement is accounted for as a purchase and an operating lease.

Sale-leaseback involving real estate.

Three requirements are necessary for a sale-lease-back involving real estate (including real estate with equipment) to qualify for sale-leaseback accounting treatment. Those sale-leaseback transactions not meeting the three requirements are accounted for using the deposit method or as a financing. The three requirements are:

The lease must be a normal leaseback (i.e., it involves active use of the leased property in the seller-lessee's trade or business during the lease term).
Payment terms and provisions must adequately demonstrate the buyer-lessor's initial and continuing investment in the property as prescribed by ASC 360-20.
Payment terms and provisions must transfer all the risks and rewards of ownership as demonstrated by a lack of continuing involvement by the seller-lessee.

Adequacy of initial and continuing investment. The buyer-lessor's initial investment is adequate if it demonstrates the buyer-lessor's commitment to pay for the property and indicates a reasonable likelihood that the seller-lessee will collect any receivable related to the leased property. The buyer-lessor's continuing investment is adequate if the buyer is contractually obligated to pay an annual amount at least equal to the amount of the annual payment sufficient to repay the principal and interest over no more than twenty years for land or the customary term of a first mortgage for other real estate.

Lack of continuing involvement by the seller-lessee. Any continuing involvement by the seller-lessee other than normal leaseback disqualifies the lease from sale-leaseback accounting treatment. Some examples of continuing involvement other than normal leaseback include

The seller-lessee has an obligation or option (excluding the right of first refusal) to repurchase the property
The seller-lessee (or party related to the seller-lessee) guarantees the buyer-lessor's investment or debt related to that investment or a specified return on that investment
The seller-lessee is required to reimburse the buyer-lessor for a decline in the fair value of the property below estimated residual value at the end of the lease term based on other than excess wear and tear
The seller-lessee remains liable for an existing debt related to the property
The seller-lessee's rental payments are contingent on some predetermined level of future operations of the buyer-lessor
The seller-lessee provides collateral on behalf of the buyer-lessor other than the property directly involved in the sale-leaseback
The seller-lessee provides nonrecourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is the leased asset
The seller-lessee enters into a sale-leaseback involving property improvements or integral equipment without leasing the underlying land to the buyer-lessor
The buyer-lessor is obligated to share any portion of the appreciation of the property with the seller-lessee
Any other provision or circumstance that allows the seller-lessee to participate in any future profits of the buyer-lessor or the appreciation of the leased property.

The inclusion of a put provision in the lease as a remedy for the occurrence of an event of default under the lease including for lessee noncompliance with financial covenants violates the continuing involvement criteria in ASC 840-40 when the transaction is part of a sale-leaseback. This would necessitate accounting for the transaction using the deposit method or as a financing depending on the application of ASC 360-20 to the circumstances.

When one member of a consolidated group provides an uncensored guarantee of lease payments for another member of the same consolidated group, this is not held to be continuing involvement on the part of the consolidated group. Therefore, sale-leaseback accounting is appropriate in the consolidated financial statements. In the separate financial statements of the subsidiary/seller-lessee, however, the guarantee is a form of continuing involvement that precludes sale-leaseback accounting because the guarantee provides the buyer-lessor with additional collateral that reduces the buyer-lessor's risk of loss (ASC 840-40-25).

An uncollateralized irrevocable letter of credit is not a form of continuing involvement that precludes sale-leaseback accounting unless a contract exists between the seller-lessee and third-party guarantor that would create collateral (e.g. right of offset of amounts on deposit). All written contracts between the seller-lessee and the issuer of the letter of credit must be evaluated to determine if other forms of collateral exist (ASC 840-40-25).

Example of accounting for a sale-leaseback transaction

To illustrate the accounting treatment in a sale-leaseback transaction, suppose that Seller/Lessee Corporation sells equipment that has a book value of $80,000 and a fair value of $100,000 to Buyer/Lessor Corporation for $100,000 in cash, and then immediately leases it back under the following conditions:

The sale date is January 1, 2012, and the equipment has a fair value of $100,000 on that date and an estimated remaining useful life of fifteen years.
The lease term is fifteen years, noncancelable, and requires equal rental payments of $13,109 at the beginning of each year.
Seller/Lessee Corp. has the option to annually renew the lease at the same rental payments upon expiration of the original lease.
Seller/Lessee Corp. has the obligation to pay all executory costs.
The annual rental payments provide the Buyer/Lessor Corp. with a 12% return on investment.
The incremental borrowing rate of Seller/Lessee Corp. is 12%.
Seller/Lessee Corp. depreciates similar equipment on a straight-line basis.

Seller/Lessee Corp. will classify the agreement as a capital lease since the lease term exceeds 75% of the estimated remaining economic life of the equipment, and because the present value of the lease payments ($13,109 × 7.62817 = $100,000)⁵ is greater than 90% of the fair value of the equipment. Assuming that collectibility of the lease payments is reasonably predictable and that no important uncertainties exist concerning the amount of unreimbursable costs yet to be incurred by Buyer/Lessor Corp., Buyer/Lessor Corp. will classify the transaction as a direct financing lease because the present value of the minimum lease payments is equal to the fair value of $100,000.

Seller/Lessee Corp. and Buyer/Lessor Corp. would make the following journal entries during the first year:

Upon Sale of Equipment on January 1, 2012

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To Record First Payment on January 1, 2012**

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To Record Incurrence and Payment of Executory Costs

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To Record Amortization Expense on the Equipment, December 31, 2012

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To Amortize Profit on Sale-Leaseback by Seller/Lessee Corp., December 31, 2012

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To Record Interest for 2008, December 31, 2012

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Partial Lease Amortization Schedule**

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Supplemental guidance.

The following paragraphs provide supplemental guidance regarding the application of sale-leaseback accounting.

Property sold subject to seller's preexisting operating lease. ASC 840-40-55 considers the situation in which the reporting entity is an investor in a partnership that owns property with respect to which the reporting entity is also a lessee under an operating lease that covers all or a portion of the property. The reporting entity sells its interest in the partnership or the partnership sells the property to an independent party with the preexisting operating lease continuing in effect.

If the leased property is within the scope of ASC 840-40 (real estate or real estate with integral equipment), ASC 840-40-55 requires recognition of the transaction as a sale-lease-back if the preexisting lease is significantly modified in connection with the sale. If no changes are made to the lease, or if changes are insignificant, then profit is deferred and recognized in accordance with ASC 360-20 and ASC 840-40 for real estate, property improvements, and integral equipment.

The computation of any deferred profit is not affected by the seller-lessee's prior ownership percentage in the property. In addition, exercise of renewal options or sublease provisions contained in the preexisting lease that were included in the original minimum lease term do not affect the accounting for the transaction. ASC 840-40 would apply, however, to renewal options not contained in the original minimum lease term. These renewal options would be treated as a new lease. Finally, leases between parties under common control are not considered preexisting leases for this purpose and ASC 840-40 applies unless one of the parties is a regulated enterprise such as a public utility under the provisions of ASC 980 (ASC 840-40-55).

Sale-leaseback of an asset leased to another party. A variation of the previous issue arises when a leaseback involves an asset that is personal property falling outside coverage of ASC 840-40 and either (1) subject to an operating lease or (2) subleased or intended to be subleased to another entity under an operating lease. The standard specified that the seller-lessee-sublessor is to account for the transaction by recording the sale, removing the asset from its statement of financial position, classifying the leaseback based on the normal criteria for determining lease classification, and recognizing or deferring any gain on the transaction as previously discussed (ASC 840-40-55).

Other Lease Issues

Accounting for a sublease.

A sublease is an arrangement where the original lessee releases the leased property to a third party (the sublessee), and the original lessee acts as a sublessor. Normally, the nature of a sublease agreement does not affect the original lease agreement, and the original lessee/sublessor retains primary liability to the lessor.

The original lease remains in effect, and the original lessor continues to account for the lease as before. The original lessee/sublessor accounts for the lease as follows:

If the original lease agreement transfers ownership or contains a BPO and if the new lease meets any one of the four specified criteria (i.e., transfers ownership, BPO, 75% test, or 90% test) and both the collectibility and uncertainties criteria, then the sublessor classifies the new lease as a sales-type or direct financing lease; otherwise it is classified as an operating lease. In either situation, the original lessee/sublessor continues accounting for the original lease obligation as before.
If the original lease agreement does not transfer ownership or contain a BPO, but it still qualifies as a capital lease, then the original lessee/sublessor (with one exception) applies the usual criteria in classifying the new agreement. If the new lease qualifies, the original lessee/sublessor accounts for it as a direct financing lease, with the unamortized balance of the asset under the original lease being treated as the cost of the leased property. However, the original lessee/sublessor should recognize a loss on the sublease if its carrying amount exceeds the total sublease rentals and the estimated residual value (ASC 840-20-25). The one exception arises when the circumstances surrounding the sublease suggest that the sublease agreement was an important part of a predetermined plan in which the original lessee played only an intermediate role between the original lessor and the sublessee. In this situation, the sublease is classified by the 75% and 90% criteria as well as collectibility and uncertainties criteria. In applying the 90% criterion, the fair value for the leased property is the fair value to the original lessor at the inception of the original lease. Under all circumstances, the original lessee continues accounting for the original lease obligation as before. If the new lease agreement (sublease) does not meet the capitalization requirements imposed for subleases, then the new lease is accounted for as an operating lease.
If the original lease is an operating lease, the original lessee/sublessor accounts for the new lease as an operating lease and accounts for the original operating lease as before.

Example of a direct-financing sublease

The Silver Pick Mine obtains a $300,000 ore carrier truck under a five-year capital lease at 8% interest. Annual lease payments are $75,137. Silver Pick reduces its lease liability in accordance with the following amortization table:

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At the end of Year 2, silver prices drop too low for ongoing mining operations to be profitable, so Silver Pick subleases the ore carrier via a direct financing lease to the Lead Bottom Mine for the remaining three years of the lease at the same interest rate. Silver Pick should use the unamortized balance of $193,635 at the end of Year 2 as the cost basis of the sublease, but Lead Bottom negotiates a lower inception value of $160,000, resulting in the following amortization table:

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At the inception of the sublease, Silver Pick records a loss of $39,156 to reflect the negotiated $33,635 drop in the cost basis of the sublease, from $193,635 to $160,000, as well as a reduction of sublease interest income of $5,521, also due to the reduced cost basis. The summary entry for the final three years of Silver Pick's payments under the original lease agreement and its receipts under the sublease follows:

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Lease escalations.

Virtually all commercial leases contain provisions obligating the lessee to pay the lessor various additional sums, often referred to as lease escalations, that supplement the specified fixed rentals. It is important that the parties to the lease properly classify these payments because the way they are characterized can affect whether the lease is accounted for in the correct manner.

Escalating base rents. These are periodic increases in the fixed monthly rentals scheduled to occur at one or more points during the lease term. Escalating base rents are included in minimum lease payments.

Variations of this type of escalation occur when the fixed (or base) rent is structured at inception to include a future escalation based on the expected growth of the lessee requiring it to physically use additional portions of the premises that it was not using at inception or an actual addition or based on the lessee actually adding space or capacity.

ASC 840-20-25 prescribes the following two rules:

If, at the inception of the lease, the lessee takes possession of or controls the physical use of the leased property, all rentals including the escalated rents are to be recognized by the lessee and lessor as rental expense and rental revenue, respectively, on a straight-line basis commencing with the beginning of the lease term.
If rents escalate under a master lease agreement because the lessee obtains access to or control of additional leased property at the time of the escalation, the escalated rents are considered by the lessee and lessor as rental expense and rental revenue respectively that is attributable to the newly leased property. This additional rental expense or rental revenue is to be computed based on the relative fair values of the original leased property and the additional leased property as determined at the inception of the lease and allocated to the time periods during which the lessee controls the use of the additional leased property.

Executory costs. These represent reimbursements to the lessor of costs associated with owning and maintaining the leased property. The most common executory costs are real estate taxes, insurance, and maintenance. Amounts paid by a lessee as consideration for a guarantee from an unrelated third party of the residual value are also considered executory costs. If executory costs are paid by the lessor, any lessor's profit on those costs is considered in the same manner as the actual executory costs. Executory costs are excluded from minimum lease payments.

Contingent rentals. These are additional rentals due that are computed based on changes that occur subsequent to the inception of the lease in factors, other than the passage of time, on which the lease payments were based. Examples of contingent rentals include real estate rentals based on a percentage of the lessee's retail sales over a certain dollar amount (often referred to as percentage rent or overage rent) and equipment rentals based on machine hours of use. One type of escalation that many commercial leases contain is a required rent increase based on increases in an index such as the prime interest rate or the Consumer Price Index (CPI). Depending on how the terms are structured, these payments might actually consist of two elements that must be separately considered. The portion attributable to the index or rate that was in effect at the inception of the lease (considered part of the minimum lease payments) and the portion representing subsequent increases in that index or rate (considered to be contingent rentals) as illustrated in the following examples.

Example 1

A three-year lease requires fixed rentals of $1,000 per month plus $10 for every full percentage point of the prime interest rate or fraction thereof determined as of the beginning of the month. The prime interest rate at the inception of the lease is 6% and on the first day of the fourth month of the lease term the prime interest rate increased to 7%.

At lease inception, the minimum rentals are computed as follows:

The increase in rent due at the beginning of the fourth month would be allocated as follows:

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Example 2

Same facts as Example 1, except that the lease requires the lessee to pay fixed rentals of $1,000 per month plus $10 for every full percentage point or fraction thereof that the prime interest rate determined as of the beginning of the month exceeds 6%.

At lease inception, the minimum rentals are computed as follows:

The increase in rent due at the beginning of the fourth month would be allocated as follows:

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As illustrated in the examples, amounts determined to be contingent rentals are excluded from minimum lease payments.

As discussed previously, leases for retail space often contain percentage rent provisions that obligate the lessee to pay the lessor a percentage of retail sales over a certain dollar amount. These dollar thresholds are often expressed in terms of annual targets such as one-half of one percent of annual sales over $10 million. This type of lease provision raises the accounting issue of how the lessor and lessee are to account for the lease during the interim periods prior to the attainment of the contractual target.

ASC 840-10-25 and ASC 840-10-40 prescribes the accounting as follows:

Lessor:	No revenue recognition until the actual target is achieved and surpassed.
Lessee:	Recognize contingent rental expense during interim periods if it is probable that the target will be reached by the end of the fiscal year. If, subsequently, the specified target is not met, previously recorded expense is reversed at the time it becomes probable that the target will not be met.

Lessee involvement in asset construction.

A lessee often has substantial involvement in construction activities with respect to an asset to be leased under a long-term lease agreement. This involvement can take many forms that can include:

Providing the construction financing directly or indirectly
Guaranteeing the construction debt
Serving as primary or secondary obligor under construction contracts
Acting as the real estate developer or general contractor
Agreeing to purchase the asset if the construction is not completed by a specified date
Agreeing to fund construction cost overruns
Serving as an agent of the lessor for the construction, financing, or ultimate sale of the asset
Agreeing to a date-certain lease that obligates the lessee to commence rental payments on a certain date irrespective of whether the construction is complete by that date.

Construction period rent associated with land and building leases. In certain instances, the lessee will delay occupancy or usage of leased property until, for example, leasehold improvements have been completed. ASC 840-20-25 states that a lease conveys to the lessee the right to control the use of property, such as leased land and building, both during and after any construction period necessary to construct leasehold improvements to the property. Consequently, rental expense is required to be allocated to periods during which construction activities are occurring even though the lessee has not yet commenced operations on the premises. It further provides that the rentals allocated to the construction period are not to be capitalized as part of the cost of the leasehold improvements but rather are to be recorded as a period expense as a charge against income from continuing operations in the lessee's financial statements.

Transfer of construction period risks. A lessee is considered the owner of a real estate project during its construction period if the lessee bears substantially all of the construction period risks (ASC 840-40).

Under ASC 840-40, if the lessee is determined to bear substantially all of the construction risks, it is considered to be the owner of the asset during the construction period. If that is the case, then a sale-leaseback of the asset occurs upon the completion of construction and the commencement of the lease term.

The primary test to be used in determining if a lessee has substantially all of the construction period risks is virtually the same as the 90% of fair value test for determining if a lease is to be classified as a capital lease by a lessee. Beginning with the earlier of the date of the inception of the lease or the date that the construction terms are agreed to, if at any time during the construction period 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, then the lessee is considered to be the owner of the real estate project during its construction period.

Even if the present value of the lessee's maximum guarantee is less than 90% of total project costs, ASC 840-40 provides six examples of when the lessee would still be considered the owner of a real estate project.

For the purposes of this 90% test, the lessee's maximum guarantee includes any payments the lessee could be required to make in connection with the construction project. The lessee's maximum guarantee includes, but is not limited to:

Lease payments that must be made regardless of when or whether the project is complete
Guarantees of the construction financing
Equity investments made in the owner-lessor or any party related to the owner-lessor
Loans or advances made to the owner-lessor or any party related to the owner-lessor
Payments made by the lessee in the capacity of a developer, a general contractor, or a construction manager/agent that are reimbursed less frequently than is normal or customary
Primary or secondary obligations to pay project costs under construction contracts
Obligations that could arise from being the developer or general contractor
An obligation to purchase the real estate project under any circumstances
An obligation to fund construction cost overruns
Rent or fees of any kind, such as transaction costs, to be paid to or on behalf of the lessor by the lessee during the construction period
Payments that might be made with respect to providing indemnities or guarantees to the owner-lessor.

The scope of ASC 840-40 includes government-owned property under construction and subject to a future lease of the completed improvements (ASC 840-40-15).

Any direct or indirect financial interests of the lessee in the leased asset or in the lessor must be analyzed by the lessee to determine if

They require accounting recognition as a guarantee obligation under ASC 460.
They result in the lessee holding a variable interest in the lessor or in the lessor's specified assets (the project) that potentially could require the lessee to consolidate the lessor as the primary beneficiary of a VIE or consolidate the specified assets and related liabilities (referred to as “silo” or a “virtual VIE”).

If the lessee consolidates the lessor or the project, intercompany transactions and balances will be eliminated in consolidation.

Change in residual value.

For any of the foregoing types of leases, the lessor is to review the estimated residual value at least annually. If there is a decline in the estimated residual value, the lessor must make a determination as to whether this decline is temporary or permanent. If temporary, no adjustment is required; however, if the decline is other than temporary, then the estimated residual value must be revised to conform to the revised estimate. The loss that arises in the net investment is recognized in the period of decline. Under no circumstance is the estimated residual value to be adjusted to reflect an increase in the estimate. ASC 840-30-35 clarifies that this prohibition against reflecting an increase in the estimated residual value also extends to increases in the guaranteed portions of the residual value that result from renegotiations between the parties.

Example of a permanent decline in residual value

Hathaway Corporation enters into a sales-type leasing transaction as the lessor of a fire truck. The following table shows key information about the lease:

Lease term	10 years
Implicit interest rate	8%
Lease payments	One payment per year
Normal selling price	$300,000
Asset cost	$200,000
Residual value	$ 50,000

After one year, immediately after the first lease payment has been received, Hathaway determines that an indicated decline in residual value from $50,000 to $30,000 is other than temporary. The calculation it originally used to determine the annual minimum lease payment follows:

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Hathaway calculates the following reduction in the residual present value of the fire truck, using a multiplier of 0.5002 to obtain the present value of the residual value due in nine years at an interest rate of 8%:

Accreted original residual asset present value = ($50,000) × (Present value of 0.5002) = $25,010

Less: Revised residual asset present value = ($30,000) × (Present value of 0.5002) = $15,006

Equals net change in residual asset present value = ($10,004)

The following table shows the original and revised elements of Hathaway's lease transaction entry:

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The following amortization table tracks the net impact of these changes, resulting in a $30,000 residual value at the end of Year 10:

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Thus, net of rounding errors, the total of all payments on the amortization table and the $30,000 revised residual value equals the revised lease receivable of $442,572. Similarly, the total of all interest payments on the amortization table matches the adjusted unearned interest entry.

Change in the provisions of a lease.

Accounting issues arise when the lessee and lessor agree, subsequent to its inception, to change the provisions of the lease (other than by renewals or term extensions that are discussed later). If, from the standpoint of the lessee, the revised lease terms would have, at the inception of the original lease, resulted in a different lease classification (e.g., operating lease versus capital lease or vice versa), the revised agreement is considered to be a new agreement.

If the original lease was accounted for as a capital lease and the revised lease qualifies for treatment as an operating lease, they are to be accounted for as sale-leaseback transactions (discussed later in this chapter).

If the original lease was accounted for as an operating lease and the revised lease is a capital lease, then on the date of the revision, the lessee records an asset and an obligation based on the present value of the remaining lease payments (or the fair value of the leased property, if less).

Finally, if the original and revised leases are both capital leases, then the lessee adjusts the recorded asset and obligation by an amount equal to the difference between the present value of the future minimum lease payments under the revised agreement and the recorded balance of the obligation. For the purposes of this calculation, the rate of interest to be used is the rate that was used to record the lease initially. The adjustment is recognized as a gain or loss of the period in which the revision is made.

In the case of either a sales-type or direct financing lease where there is a change in the provisions of a lease, the lease is accounted for by the lessor as discussed below.

Changes in the provisions that affect the amount of the remaining minimum lease payments can result in one of the following three outcomes:

The change does not give rise to a new agreement. A new agreement is defined as a change that, if in effect at the inception of the lease, would have resulted in a different classification.
The change does give rise to a new agreement that would be classified as a direct financing lease.
The change gives rise to a new agreement that would be classified as an operating lease.

If either item 1 or item 2 occurs, the balance of the minimum lease payments receivable and the estimated residual value (if affected) are adjusted to reflect the effect of the change. The net adjustment is charged (or credited) to unearned income, and the accounting for the lease over its remaining term is adjusted to reflect the change.

If the new agreement is an operating lease, then the remaining net investment (lease receivable less unearned income) is written off and the leased asset is recorded by the lessor at the lower of its cost, present fair value, or carrying value. The net adjustment resulting from these entries is charged (or credited) to income of the period in which the revision is made. Thereafter, the new lease is accounted for as any other operating lease.

The lessee and the lessor may negotiate a shortened lease term and an increase in the lease payments over the revised lease term. ASC 840-20-55 observes that the nature of the modification is a matter of judgment that depends on the relevant facts and circumstances. If the modification is deemed only a change in future lease payments, the increase is amortized over the remaining term of the modified lease. On the other hand, a modification deemed a termination penalty is to be recognized in the period of modification. Termination penalties are calculated as the excess of the modified lease payments over the original lease payments that would have been required during the shortened lease term.

ASC 840-20-55 provides that consideration is to be given to (1) the length of the modified lease period compared to the remaining term of the original lease, and (2) the difference between the modified lease payments and comparable market rents in determining whether the modification is a termination penalty.

Early termination of a lease.

Accounting for premature lease termination from the standpoints of the lessee and lessor follows.

Lessee accounting. Discontinuation of business activities in a particular location is considered an exit activity, the accounting for which is specified in ASC 420.

Operating leases. In connection with lease termination, the lessee may incur (1) costs to terminate the lease prior to the end of its noncancelable term and/or (2) continuing lease costs incurred during the remainder of the lease term for which the lessee receives no economic benefit because the premises are no longer in use. On the date the lessee terminates the lease, the lessee recognizes a liability for the fair value of the termination costs. The termination date is the date that the lessee provides written notice to the lessor in accordance with the notification requirements contained in the lease or the date the lessee and lessor agree to a negotiated early termination.

The fair value of rentals that continue to be incurred under the lease during its remaining term without benefit to the lessee is recognized as a liability on the date that the lessee ceases to use the property (referred to as the cease-use date). Fair value is computed based on the remaining rentals due under the lease, adjusted for any prepaid or deferred rent under the lease, and reduced by estimated sublease rentals that are reasonable to expect for the property. The fair value measurement requires that reasonable sublease rentals be included in the computation even if the lessee does not intend to sublease the property.

In periods subsequent to the recognition of these liabilities but prior to their settlement, changes in fair value are measured using the credit-adjusted risk-free rate of interest (in essence, the lessee's incremental borrowing rate) used to initially measure the liability.

Upon initial recognition of these liabilities, the related costs are recognized in the lessee's income statement as operating expense (or income from continuing operations if no measure of operations is presented) unless required to be presented as part of discontinued operations. The cumulative effects of any subsequent period changes in liabilities that result from changes in the estimates of either the amounts or timing of cash flows are reported in the same income statement caption used to initially recognize the costs. Changes to the liabilities as a result of the passage of time increase their carrying amount and are recorded as accretion expense, which is also considered an operating expense.

Capital leases. If the lease is a capital lease, it is subject to the provisions of ASC 360 with respect to long-lived assets to be disposed of other than by sale (see Chapter 14) either individually (in which case the gain or loss is recorded as a component of operating expense) or as part of a disposal group (in which case the gain or loss is presented as a part of discontinued operations). During the time period between the termination date and the cease-use date, the capital lease asset continues to be classified as “held and used,” is subject to impairment evaluation, and its remaining carrying value is amortized over that shortened time period.

Lessor accounting. Lessor accounting for an early lease termination is as follows.

Sales-type and direct financing leases. The lessor records the leased equipment as an asset at the lower of its original cost, present fair value, or current carrying value. The difference between the remaining net investment in the lease and the amount of the adjustment to recognize the leased equipment is reflected in income of the period in which the lease is terminated.

Example of lessor accounting for the early termination of a sales-type lease

La Crosse Corporation enters into a sales-type leasing transaction as the lessor of a digital color copier. The following table shows key information about the lease:

Lease term	5 years
Implicit interest rate	8%
Lease payments	One payment per year
Normal selling price	$80,000
Asset cost	$50,000
Residual value	$10,000
Present value of ordinary annuity of 1 for 5 years at 8%	3.9927
Present value of 1 due in 5 years at 8%	0.6806

Based on the information in the table, La Crosse calculates an annual minimum lease payment of $18,332, which is reflected in the following amortization table:

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At the end of Year 3, the lessee cancels the lease. At that time, the fair value of the color copier is $35,000, which is $6,263 less than the $41,263 current carrying value indicated at the end of Year 3 in the amortization table. This change is reflected in the following table, which notes the original and revised elements of La Crosse's lease transaction:

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Operating leases. Accounting for the leased asset is subject to the provisions of ASC 360. Between the termination date and the cease-use date, the leased asset continues to be presented as held-and-used and depreciated subject to an impairment evaluation that considers the likelihood and timing of replacing the tenant and market rents that would be realized. On the cease-use date, the leased asset is reclassified from held-and-used to the category of idle property and equipment with the associated temporary suspension of depreciation.

Upon receiving notice of termination, the lessor recognizes a receivable for the fair value of any termination fees to be received from the lessee as a result of early cancellation and a corresponding deferred rent liability that is recorded as an adjustment to any previously recorded deferred rent liability or prepaid rent. The remaining rental stream to be received thereafter is recognized on a straight-line basis over the remainder of the time period during which such payments were agreed to continue by adjusting any remaining prepaid rent, deferred rent, and/or unamortized initial direct costs so that they will be fully amortized by the date on which the lessee's payment obligation is fully satisfied.

Renewal or extension of an existing lease.

The renewal or extension of an existing lease agreement affects the accounting of both the lessee and the lessor. There are two basic situations: (1) the renewal occurs and makes a residual guarantee or penalty provision inoperative or (2) the renewal agreement does not do the foregoing and the renewal is treated as a new agreement. The accounting treatment prescribed under the latter situation for a lessee is as follows:

If the renewal or extension is classified as a capital lease, then the (present) current balances of the asset and related obligation are adjusted by the difference between the present value of the future minimum lease payments under the revised agreement and the (present) current balance of the obligation. The present value of the minimum lease payments under the revised agreement is computed using the interest rate in effect at the inception of the original lease.
If the renewal or extension is classified as an operating lease, then the current balances of the asset and liability are written off and a gain (loss) recognized for the difference. The new lease agreement resulting from a renewal or extension is accounted for in the same manner as other operating leases.

Under the same circumstances, the following treatment is followed by the lessor:

If the renewal or extension is classified as a direct financing lease, then the existing balances of the lease receivable and the estimated residual value are adjusted for the changes resulting from the revised agreement.

NOTE: Remember that an upward adjustment to the estimated residual value is not allowed.

The net adjustment is charged or credited to unearned income.
If the renewal or extension is classified as an operating lease, then the remaining net investment under the existing sales-type lease or direct financing lease is written off and the leased asset is recorded as an asset at the lower of its original cost, present fair value, or current carrying amount. The difference between the net investment and the amount recorded for the leased asset is charged to income of the period that includes the renewal or extension date. The renewal or extension is then accounted for prospectively as any other operating lease.
If the renewal or extension is classified as a sales-type lease and it occurs at or near the end of the existing lease term, then the renewal or extension is accounted for as a sales-type lease.

NOTE: 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.

If the renewal or extension causes the guarantee or penalty provision to be inoperative, the lessee adjusts the current balance of the leased asset and the lease obligation to the present value of the future minimum lease payments (according to ASC 840 “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 is computed using the rate used in the original lease agreement.

Given the same circumstances, the lessor adjusts the existing balance of the lease receivable and estimated residual value to reflect the changes of the revised agreement (remember, no upward adjustments to the residual value). The net adjustment is charged (or credited) to unearned income.

Example of lessor accounting for extension of a sales-type lease

Entré Computers enters into a sales-type leasing transaction as the lessor of a corporate computer system. The following table shows key information about the lease:

Lease term	6 years
Implicit interest rate	10%
Lease payments	One payment per year
Normal selling price	$240,000
Asset cost	$180,000
Residual value	$450,000
Present value of ordinary annuity of 1 for 6 years at 10%	4.3553
Present value of 1 due in 6 years at 10%	0.5645

Based on the information in the table, Entré calculates an annual minimum lease payment of $49,273, which is reflected in the following amortization table:

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After making the Year 3 payment, the lessee requests a lease extension in order to reduce the annual payment amount. To do so, Entré extends the lease duration by two years and assumes the same residual value. Entré calculates the revised annual minimum lease payment under the assumption that the selling price is the balance of the net investment at the end of Year 3, as noted in the preceding amortization table.

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The revised lease payment and residual value is shown in the following amortization table, which includes both the first three years of the original lease agreement and the full five years of the lease extension agreement:

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This change is reflected in the following table, which notes the original and revised elements of Entré's lease transaction:

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Leases between related parties.

Leases between related parties are classified and accounted for as though the parties are unrelated, except in cases where it is certain that the terms and conditions of the agreement have been influenced significantly by the fact that the lessor and lessee are related. When this is the case, the classification and/or accounting is modified to reflect the true economic substance of the transaction rather than the legal form. Under ASC 810, discussed earlier in this chapter, many related-party lessors will qualify as VIEs. When this is the case, the lessee will present consolidated financial statements that include the lessor's assets, liabilities, and results of operations. The elimination of intercompany transactions and balances will result in the rental expense and rental income being removed from the consolidated financial statements, which will instead reflect the depreciation of the leased asset and the interest expense on any related debt.

ASC 850 requires that the nature and extent of leasing activities between related parties be disclosed. ASC 810 requires the following disclosures by the primary beneficiary of a VIE:

The nature, purpose, size, and activities of the VIE
The carrying amount and classification of consolidated assets that collateralize the VIE's obligations
Any lack of recourse that VIE creditors or holders of VIE beneficial interests have to the general credit of the primary beneficiary.

Indemnification provisions in lease agreements.

Some lease agreements contain a provision whereby the lessee indemnifies the lessor on an after-tax basis for certain income tax benefits that the lessor might lose if a change in the income tax law should occur.

An indemnification agreement of this kind is considered a guarantee that is subject to the recognition and disclosure requirements of ASC 460. Any payments that might be required under the indemnification clause are, therefore, not considered contingent rentals.

Accounting for leases in a business combination.

A business combination, in and of itself, has no effect upon the classification of a lease. However, if, in connection with a business combination, a lease agreement is modified to change the original classification of the lease, it is considered a new agreement and accounted for as previously discussed.

In most cases, a business combination will not affect the previous classification of a lease unless the provisions have been modified as indicated in the preceding paragraph.

The acquiring company applies the following procedures to account for a leveraged lease in a business combination:

The classification as a leveraged lease is retained.
The net investment in the leveraged lease is assigned a fair value (present value, net of income taxes) based upon the remaining future cash flows. Also, the estimated income tax effects of the cash flows are recognized.
The net investment is broken down into three components: net rentals receivable, estimated residual value, and unearned income.
Thereafter, the leveraged lease is accounted for as described in the discussion earlier in this chapter.

ASC 805 significantly alters the accounting for business combinations. It requires the use of the acquisition method, which requires that assets acquired and liabilities assumed in such a transaction be accounted for at fair values. This means, among other things, that capital leases under which the acquiree entity was obligated at the acquisition date are to be revalued at fair value at the date of the acquisition. The amounts of depreciation and interest to be recognized in subsequent periods by the acquirer will accordingly, in most instances, vary from the amounts that would have been recognized by the acquiree absent the business combination.

For example, if the fair value of the leased property under a capital lease is greater than its carrying value (the depreciated capitalized value as of that date), future amortization will be greater than would otherwise have been the case. Given that rental payments will not be altered by the acquisition transaction, this means that the effective interest cost will be reduced. A new effective interest rate will need to be computed in order to properly record the accounting implications of future rental payments, in such a circumstance. Contrariwise, if the fair value of the leased property is lower than its precombination carrying (book) value, the effective interest rate will be greater than had previously been determined.

ASC 805 states that the determination of the classification of an existing lease is generally not reassessed at the date of a business combination, and that the determination made at the lease inception is not to be reconsidered. However, if the terms of an operating lease are favorable or unfavorable compared with the market terms of leases of the same or similar items at the acquisition date, accounting ramifications must be addressed. The acquirer in such a circumstance is to recognize an intangible asset if the terms of an operating lease are favorable relative market terms, and is to recognize a liability if the terms are unfavorable relative to market terms.

An identifiable intangible asset may be associated with an operating lease, which may be objectively revealed by market participants' willingness to pay a price for the lease even if its terms are already at market. For example, a lease of gates at an airport or of retail space in a prime shopping area might provide entry into a market or other future economic benefits that qualify as identifiable intangible assets—for example, as a customer relationship. In that situation, the acquirer is to recognize the associated identifiable intangible asset(s). Under ASC 805, the identifiable intangible assets acquired in a business combination are to be recognized distinct from goodwill. An intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion described by ASC 805.

If the acquiree in a business combination has assets (e.g., building or equipment) that are subject to operating leases (that is, the acquiree is a lessor), ASC 805 directs that such assets are to be recorded at fair value determined without regard to the terms of the associated leases. The extent to which the lease terms are favorable or unfavorable relative to the market at the acquisition date, however, will be reflected in the additional intangible asset or liability to be recognized by the acquirer.

Accounting for changes in lease agreements resulting from refunding of tax-exempt debt.

Tax-exempt debt is often “refunded” by the issuer of the debt instruments. Refunding is a refinancing that enables the issuer (i.e., a municipality that issued bonds) to take advantage of favorable interest rates. A current refunding is effected when the debt becomes callable and the issuer issues new debt in order to use the proceeds to retire the original debt. An advance refunding is a more complex variation that occurs prior to the call date of the original instruments. It entails issuance of new tax-exempt debt at the lower interest rate with a similar maturity to the original issuance. The proceeds of the new debt are invested in a portfolio of market-traded US Treasury securities and other obligations that effectively “defease” the original bonds. If, during the lease term, a change in the lease results from a refunding by the lessor of tax-exempt debt (including an advance refunding) and (1) the lessee receives the economic advantages of the refunding and (2) the revised agreement can be classified as a capital lease by the lessee and a direct financing lease by the lessor, the change is accounted for as follows:

If the change is accounted for as an extinguishment of debt:
1. Lessee accounting. The lessee adjusts the lease obligation to the present value of the future minimum lease payments under the revised agreement. The present value of the minimum lease payments is computed using the interest rate applicable to the revised agreement. Any gain or loss is recognized currently as a gain or loss on the extinguishment of debt in accordance with the provisions of ASC 470-50-45 (discussed in detail in the chapter on ASC 470).
2. Lessor accounting. The lessor adjusts the balance of the lease receivable and the estimated residual value, if affected, for the difference in present values between the old and revised agreements. Any resulting gain or loss is recognized currently.
If the change is not accounted for as an extinguishment of debt:
1. Lessee accounting. The lessee accrues any costs in connection with the debt refunding that are obligated to be reimbursed to the lessor. These costs are amortized by the interest method over the period from the date of refunding to the call date of the debt to be refunded.
2. Lessor accounting. The lessor recognizes as revenue any reimbursements to be received from the lessee, for costs paid in relation to the debt refunding. This revenue is recognized in a systematic manner over the period from the date of refunding to the call date of the debt to be refunded.

Sale or assignment to third parties; nonrecourse financing.

The sale or assignment of a lease or of property subject to a lease that was originally accounted for as a sales-type lease or a direct financing lease will not affect the original accounting treatment of the lease. Any profit or loss on the sale or assignment is recognized at the time of the transaction, except under the following two circumstances:

When the sale or assignment is between related parties, apply substance versus form provisions presented above under “leases between related parties.”
When the sale or assignment is with recourse, it is accounted for using the provisions of ASC 860.

The sale of property subject to an operating lease is not treated as a sale if the seller (or any related party to the seller) retains “substantial risks of ownership” in the leased property. A seller may retain “substantial risks of ownership” by various arrangements. For example, if the lessee defaults upon the lease agreement or if the lease terminates, the seller may arrange to do one of the following:

Acquire the property or the lease
Substitute an existing lease
Secure a replacement lessee or a buyer for the property under a remarketing agreement.

A seller does not retain substantial risks of ownership by arrangements where one of the following occurs:

A remarketing agreement includes a reasonable fee to be paid to the seller.
The seller is not required to give priority to the releasing or disposition of the property owned by the third party over similar property owned by the seller.

When the sale of property subject to an operating lease is not accounted for as a sale because the substantial risk factor is present, it is accounted for as a borrowing. The proceeds are recorded by the seller as an obligation. Rental payments made by the lessee under the operating lease are recorded as revenue by the seller even if the payments are paid to the third-party purchaser. The seller accounts for each rental payment by allocating a portion to interest expense (to be imputed in accordance with the provisions of ASC 835-30), and the remainder to reduce the existing obligation. Other normal accounting procedures for operating leases are applied except that the depreciation term for the leased asset is limited to the amortization period of the obligation.

The sale or assignment of lease payments under an operating lease by the lessor are accounted for as a borrowing as described above.

Nonrecourse financing is a common occurrence in the leasing industry, whereby the stream of lease payments on a lease is discounted on a nonrecourse basis at a financial institution with the lease payments collateralizing the debt. The proceeds are then used to finance future leasing transactions. Even though the discounting is on a nonrecourse basis, the offsetting of the debt against the related lease receivable is prohibited unless a legal right of offset exists or the lease qualified as a leveraged lease at its inception.

Money-over-money lease transactions.

A money-over-money lease transaction occurs when 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. ASC 840-30-55 prescribes that this series of transactions should be accounted for as follows:

Record the purchase or manufacture of the asset,
Record the lease as an operating, direct financing, or sales-type lease as appropriate,
Record nonrecourse debt.

The only income that is recognizable by the reporting entity in this transaction would be any manufacturer's or dealer's profit that arises if the lease is classified as a sales-type lease. With respect to the presentation in the statement of financial position, offsetting of any assets recorded as a result of the transaction with the nonrecourse debt is not permitted unless a right of setoff exists.

Wrap-lease transactions.

A wrap-lease transaction (see diagram) occurs when a reporting enterprise

Purchases an asset,
Leases the asset to a lessee,
Obtains nonrecourse financing using the lease rentals and/or the asset as collateral,
Sells the asset to an investor, subject to the lease and the nonrecourse debt, and
Leases the asset back while remaining the substantive principal lessor under the original lease.

If the asset is real estate, the specialized rules with respect to sale-leaseback of real estate set forth in ASC 840-40 apply (see example of accounting for a sale-leaseback transaction in this chapter).

If the asset is personal property, the accounting would be as follows:

The asset is removed from the accounting records of the original reporting entity
The leaseback is classified in accordance with the normal criteria for the classification of leases
Gain on the transaction is recognized or deferred/amortized following the criteria in ASC 840-40-25
The reporting entity reflects the following items on its statement of financial position:
1. Any retained interest in the residual value of the leased asset
2. Gross sublease receivable
3. Note receivable from the investor
4. Nonrecourse third-party debt
5. Leaseback obligation
6. Deferred revenue related to any future remarketing rights for which the remarketing services had not yet been performed.

The sublease asset and related nonrecourse debt are not permitted to be offset on the statement of financial position unless a right of setoff exists.

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Transfers of residual value (ASC 860).

Acquisitions of interests in residual values of leased assets may be effected by companies whose primary business is other than leasing or financing. This generally occurs through the outright purchase of the right to own the leased asset or the right to receive the proceeds from the sale of a leased asset at the end of its lease term.

In instances such as these, the rights are recorded by the purchaser at the fair value of the assets surrendered net of the present value of any liabilities assumed, unless the fair value of the residual is more objectively determinable. Increases in the estimated value of the interest in the residual (i.e., residual value accretion) to the end of the lease term are permitted to be recognized only for guaranteed residual values because they are financial assets. However, recognition of such increases is prohibited for unguaranteed residual values. A nontemporary write-down of a residual value interest (guaranteed/unguaranteed) is recognized as a loss and is not permitted to be subsequently restored. This guidance also applies to lessors who sell the related minimum lease payments but retain the interest in the residual value irrespective of whether the residual is guaranteed.

Example of the transfer of residual value

Longbottom Lease Brokers obtains an interest in the residual value of a cable placer truck as a fee for its assistance in leasing the truck to a third party. The fair value of Longbottom's interest in the residual value of the truck is estimated by an appraiser to be $47,000. Since the fair value of Longbottom's interest in the residual value is the most clearly evident valuation, Longbottom uses it as the basis for the following entry:

In another transaction, Longbottom pays $32,000 for the residual value of an aerial truck. Longbottom records the transaction as follows:

After six months, Longbottom appraises its interest in the residual value of both trucks, and finds that the value of the cable placer has declined from $47,000 to $41,000, while the residual value of the aerial truck has increased from $32,000 to $35,000. Longbottom uses the following entry to record the reduction of value in its cable placer truck:

Longbottom records no entry for the $3,000 increase in value of its aerial truck.

Leases involving government units.

Leases that involve government units (i.e., airport facilities, bus terminal space, etc.) usually contain special provisions that prevent the agreements from being classified as anything but operating leases. These special provisions, referred to as fiscal funding clauses, include the governmental body's authority to abandon a facility at any time during the lease term, thus making its economic life indeterminable. These leases also do not contain a BPO or transfer ownership. The fair value is generally indeterminable because neither the leased property nor similar property is available for sale.

However, leases involving government units are subject to the same classification criteria as nongovernment units, except when all of the following six criteria are met:

NOTE: If all six conditions are met, the agreement is classified as an operating lease by both lessee and lessor.

A government unit or authority owns the leased property.
The leased property is part of a larger facility operated by or on behalf of the lessor.
The leased property is a permanent structure or part of a permanent structure that normally cannot be moved to another location.
The lessor, or a higher governmental authority, has the right to terminate the lease at any time under the lease agreement or existing statutes or regulations.
The lease neither transfers ownership nor allows the lessee to purchase or acquire the leased property.
The leased property or similar property in the same area cannot be purchased or leased from anyone else.

If any one of the six conditions that qualify the lease for automatic operating lease treatment is not met, then the lease is evaluated to determine the likelihood of future cancellation. Using the loss contingency criteria from ASC 450, if it is remote (i.e., the chances are slight) that the lease will be canceled, then the lease agreement qualifies as a noncancelable lease and is classified the same as any other such lease with a nongovernmental lessee. Otherwise, the lease is considered to be cancelable and accounted for as an operating lease (ASC 840-10-25).

Maintenance deposits by lessees.

In some lease arrangements, the lessee may be required to make a deposit associated with the lessee's responsibility for the maintenance of the leased asset. Under a typical arrangement of this sort, the deposit is calculated based on a performance measure, such as hours of use of the leased asset, and is contractually required under the lease to be used to reimburse the lessee for required maintenance of the leased asset upon the completion of that maintenance. The lessor is thus contractually required to reimburse the lessee for the maintenance costs paid by the lessee, to the extent of the amounts on deposit. If the cumulative maintenance costs are less than the amount deposited, the excess may or may not be required to be returned to the lessee.

ASC 840-10-25 and ASC 840-10-35 address this issue. Maintenance deposits paid by a lessee under an arrangement accounted for as a lease that are refunded only if the lessee performs specified maintenance activities are to be accounted for as a deposit asset. Lessees must continue to evaluate whether it is probable that an amount on deposit will be returned to reimburse the costs of the maintenance activities incurred by the lessee. When an amount on deposit is less than probable of being returned, it is to be recognized as additional expense. When the underlying maintenance is performed, the maintenance cost is to be expensed or capitalized in accordance with the lessee's existing maintenance accounting policy.

Entities are to recognize the effect of the change as a change in accounting principle as of the beginning of the fiscal year in which this requirement is initially applied for all arrangements existing at the effective date. The cumulative effect of the change in accounting principle is to be recognized as an adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that fiscal year, presented separately. The cumulative effect adjustment is the difference between the amounts recognized in the statement of financial position before initial application of this requirement and the amounts recognized in the statement of financial position at its initial application.

Leasehold improvements.

Leasehold improvements result when tangible physical enhancements are made to property by or on behalf of the lessee of real estate. By law, when improvements are made to real property and those improvements are permanently affixed to the property, the title to those improvements automatically transfers to the owner of the property. The rationale behind this is that the improvements, when permanently affixed, are inseparable from the rest of the real estate.

As a result of this automatic title transfer, the lessee's interest in the improvements is not a direct ownership interest but rather it is an intangible right to use and benefit from the improvements during the term of the lease. Consequently, the capitalized costs incurred by a lessee in constructing improvements to property that it leases represent an intangible asset analogous to a license to use them. Thus, when allocating the costs of leasehold improvements to the periods benefited, the expense is referred to as amortization (as used in the context of amortization of intangibles) and not depreciation.

A frequently encountered issue with respect to leasehold improvements relates to determination of the period over which they are to be amortized. Normally, the cost of long-lived assets is charged to expense over the estimated useful lives of the assets. However, the right to use a leasehold improvement expires when the related lease expires, irrespective of whether the improvement has any remaining useful life. Thus, the appropriate useful life for a leasehold improvement is the lesser of the useful life of the improvement or the term of the underlying lease. ASC 840-10-35-9 reinforces this concept by requiring that leasehold improvements acquired in a business combination or leasehold improvements completed well after commencement of a lease agreement be amortized over the lesser of the useful life of the leasehold improvement or a time period that includes required lease periods as well as reasonably assured lease renewal periods.

Some leases contain a fixed, noncancelable term and additional renewal options. When considering the term of the lease for the purposes of amortizing leasehold improvements, normally only the initial fixed noncancelable term is included. There are exceptions to this general rule that arise out of the application of GAAP to the lessee's accounting for the lease. If a renewal option is a bargain renewal option, then it is probable at the inception of the lease that it will be exercised and, therefore, the option period is included in the lease term for purposes of determining the amortizable life of the leasehold improvements. Additionally, under the definition of the lease term there are other situations where it is probable that an option to renew for an additional period would be exercised. These situations include periods for which failure to renew the lease imposes a penalty on the lessee in such amount that a renewal appears, at the inception of the lease, to be reasonably assured. Other situations of this kind arise when an otherwise excludable renewal period precedes a provision for a bargain purchase of the leased asset or when, during periods covered by ordinary renewal options, the lessee has guaranteed the lessor's debt on the leased property.

In deciding whether to include the period covered by a renewal option in the calculation of the amortizable life of the leasehold improvements, management of the lessee must be consistent with its own interpretation of renewal options that it included in the minimum lease payment calculations made to determine whether the lease is a capital or operating lease.

Example

Marcie Corporation occupies a warehouse under a five-year operating lease commencing January 1, 2012, and expiring December 31, 2016. The lease contains three successive options to renew the lease for additional five-year periods. The options are not bargain renewals, as they call for fixed rentals at the prevailing fair market rents that will be in effect at the time of exercise. When the initial calculation was made to determine whether the lease is an operating lease or a capital lease, only the initial noncancelable term of five years was included in the calculation. Consequently, for the purpose of determining the amortizable life of any leasehold improvements made by Marcie Corporation, only the initial five-year term is used. If Marcie Corporation decides, at the beginning of year four of the lease, to make a substantial amount of leasehold improvements to the leased property, it could be argued that it would now be probable that Marcie would exercise one or more of the renewal periods, since not doing so would impose the substantial financial penalty of abandoning expensive leasehold improvements. This would trigger accounting for the lease as if it were a new agreement and would require testing to determine whether the lease, prospectively, qualifies as a capital or operating lease.

The SEC has provided the following guidance on the proper accounting treatment by a lessee for incentives or allowances provided by a lessor to a lessee under an operating lease.⁶

The incentives are not permitted to be netted against the leasehold improvements they were intended to subsidize. Instead, they are to be recorded as deferred rent and amortized as reductions to lease expense over the lease term.
The leasehold improvements are to be recorded gross, at their cost, and amortized as discussed above.
The lessee's cash flow statement is to reflect the cash received from the lessor as an incentive or allowance as cash provided by operating activities and the acquisition of the leasehold improvements as cash used for investing activities.

Note that this guidance is a reasonable interpretation of GAAP as it applies to all entities, not just those subject to the jurisdiction of the SEC.

Statement of financial position classification.

The balance of the lease payments receivable (lessor) and the lease obligation (lessee) must be allocated between their current and noncurrent portions. First, the current portion is computed at the date of the financial statements as the present value of the lease payments (or receipts) to be paid (received) within twelve months of the date of the statement of financial position. The noncurrent portion is computed as the difference between the current portion and the balance of the lease obligation at the end of the period. The conceptual justification for this treatment is the fact that the total lease obligation is equal to the present value of the future minimum lease payments. Therefore, it follows that the current portion is the present value of the lease payments due within one year while the noncurrent portion is the present value of all other remaining lease payments.

Summary of Accounting for Selected Items

(see following page)

TREATMENT OF SELECTED ITEMS IN ACCOUNTING FOR LEASES

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¹ A direct financing lease must have its cost or carrying value equal to the fair value of the asset at the lease's inception. So even if the amounts are not significantly different, leveraged lease accounting may not be used.

² Adapted from “A Straightforward Approach to Leveraged Leasing” by Pierce R. Smith, The Journal of Commercial Bank Lending, July 1973, pp. 40-47.

³ The ITC was repealed, effective January 1, 1986. ITC was relevant only for property placed in service prior to this date. We continue to discuss these concepts because Congress has historically reinstated this credit during economic downturns.

⁴ 6.75902 is the present value of an annuity due for ten periods at 10%.

⁵ 7.62817 is the present value of an annuity due for fifteen periods at a 12% interest rate.

⁶ Letter from SEC Chief Accountant to the chairman of the American Institute of Certified Public Accountants (AICPA) Center for Public Company Audit Firms (CPCAF) dated February 7, 2005; www.sec.gov/info/accountants/staffletters/cpcaf020705.htm

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Table of Contents for 53 ASC 840 LEASES

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53 ASC 840 LEASES

PERSPECTIVE AND ISSUES

Subtopics

Scope and Scope Exceptions

Overview

Variable interest entities.

DEFINITIONS OF TERMS

CONCEPTS, RULES, AND EXAMPLES

Variable Interest Entities

Decision diagrams.

Definition of a business.

Variable interests in “silos.”

Analysis under ASC 810

Other lease terms and provisions.

Lease or Sale—The Interplay of Lease and Revenue Recognition Accounting

ASC 840-10-35: Determining whether an arrangement contains a lease.

Sales with a guaranteed minimum resale value.

Equipment sold and subsequently repurchased subject to an operating lease.

Lessee Classification

Lessor Classification

Distinctions among sales-type, direct financing, and leveraged leases.

Lessee Accounting

Operating leases.

Capital leases.

Lessor Accounting

Operating leases.

Sales-type leases.

Direct financing leases.

Leveraged leases.

Real Estate Leases

Leases involving only land.

Leases involving land and building.

Leases involving real estate and equipment.

Leases involving only part of a building.

Operating leases with guarantees.

Lessee-incurred real estate development or construction costs.

Sale-Leaseback Transactions

Retention of rights to use the property.

Sale-leaseback involving real estate.

Supplemental guidance.

Other Lease Issues

Accounting for a sublease.

Lease escalations.

Lessee involvement in asset construction.

Change in residual value.

Change in the provisions of a lease.

Early termination of a lease.

Renewal or extension of an existing lease.

Leases between related parties.

Indemnification provisions in lease agreements.

Accounting for leases in a business combination.

Accounting for changes in lease agreements resulting from refunding of tax-exempt debt.

Sale or assignment to third parties; nonrecourse financing.

Money-over-money lease transactions.

Wrap-lease transactions.

Transfers of residual value (ASC 860).

Leases involving government units.

Maintenance deposits by lessees.

Leasehold improvements.

Statement of financial position classification.

Summary of Accounting for Selected Items

Table of Contents for
53 ASC 840 LEASES