Accounting Policy & Practice Report: News Archive 2017 June 06/09/2017 BNA Insights

Leasing Jeffrey Ellis is a Senior Managing Director at FTI Consulting and is based in Chicago. He has extensive experience advising clients on the accounting for complex transactions and identifying alternative structures to meet client business needs and accounting objectives. Mr. Ellis has assisted law firms on a wide range of matters involving accounting issues, including investigating financial statement restatements and examining structured transactions to determine if the accounting violated generally accepted accounting principles, assisted companies in implementing new accounting standards, and provided advice to companies on financial statement restatements and conversions to International Financial Reporting Standards. In addition, Mr. Ellis has testified as an accounting expert in disputes over leveraged lease transactions.

Lease Classification Under ASC 842

By Jeffrey Ellis This article is the second in a series of articles exploring the new guidance on accounting for leases (Accounting Standards Codification 842) issued by the Financial Accounting Standards Board (FASB) in February 2016. This article discusses the classification criteria of ASC 842 and highlights how classification could differ from the existing guidance in ASC 840. ASC 842, similar to ASC 840, requires lessees and lessors to determine the classification of leases. Lessees will classify leases as either finance or operating leases, while lessors will classify leases as either sales­type, direct financing or operating leases. Under ASC 842, lessees and lessors will determine the classification of a lease at the “commencement date of the lease,” or the date that the lessor has made the leased asset available to the lessee. Paragraph 2 of ASC 842­10­25 states, in part: A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales­type lease when the lease meets any of the following criteria:

a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. c. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842­10­30­5(f) equals or exceeds substantially all of the fair value of the underlying asset.

e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

If none of the criteria are met, a lessee classifies the lease as an operating lease. A lessor is required to consider the criteria in paragraph 3(b) of ASC 842­10­25, which states, in part: A lessor shall classify the lease as an operating lease unless both of the following criteria are met, in which case the lessor shall classify the lease as a direct financing lease:

1. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842­10­30­5(f) and/or [a residual value guarantee provided by] any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.

2. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

Regardless of how a lease is classified, a lessee will be required to recognize a right­of­use asset and a lease liability for substantially all leases at the commencement date. However, similar to ASC 840, the classification of a lease under ASC 842 will affect the lessee's subsequent accounting. Only leases that qualify as short­term leases (an arrangement with a lease term of 12 months or less) are exempt from recognition on the balance sheet. Differences from ASC 840 ASC 842 makes a number of changes from ASC 840 in determining the classification of a lease, including: • When the classification of a lease is determined;

• How the classification criteria are applied;

• How lease payments are determined;

• The effect of collectibility and future costs on lease classification by a lessor;

• Determining the interest rate implicit in the lease;

• Determining the incremental borrowing rate.

Those changes could have a significant effect on lease classification. Each change, and the potential impact on lease classification, is discussed further below. Timing of Lease Classification ASC 842 requires lessees and lessors to determine lease classification at the date the lessor makes the leased asset available for use by the lessee. Under ASC 840, lessees and lessors determine lease classification at the inception of the lease, which is the earlier of the date of the lease agreement or the commitment date. While in many cases the change from determining lease classification at the commitment date rather than at lease inception will not affect the outcome, if there is a significant period between the date of the lease agreement and the date that the lessor makes the asset available to the lessee (such as when the lessor is constructing the asset to be leased), changes in interest rates and/or the fair value of the asset subsequent to the date of the lease agreement could affect classification because the discount rate and leased asset fair value used in determining if the present value of the lease payments equals or exceeds substantially all of the fair value of the underlying asset are determined at the commencement date. For example, if interest rates decline between the date of the lease agreement and the commencement date and the payments that were established in an environment characterized by higher interest rates are not indexed to changes in those interest rates, a lessee could find that a lease that would have been classified as an operating lease had classification been determined at lease inception is now a finance lease at the commencement date. Classification Criteria The lease classification criteria in ASC 842 were derived from the lease classification criteria in International Accounting Standards 17 Leases. However, that change should not have a significant impact on the classification of most leases, at least for lessees. The first two criteria are the same as the criteria in paragraphs 1(a) and 1(b) of ASC 840­10­25. Accordingly, ASC 842 should not change the classification of leases that met either of those criteria under ASC 840. The third and fourth criteria in ASC 842 reflect the “principles­based” approach in IAS 17, which differed from the “bright­line” classification approach in ASC 840. On its face, the changed wording would appear to indicate that a reporting entity could end up with a different classification under ASC 842, particularly for leases that are structured to have lease terms close to 75 percent of the leased asset's estimated economic life or to have the present value of the lease payments be slightly less than 90 percent of the asset's fair value. However, in applying those criteria, paragraph 2 of ASC 842­10­55 indicates that a reporting entity could elect to define “major part of the remaining economic life of the underlying asset” as 75 percent and “equals or exceeds substantially all of the fair value of the underlying asset” as 90 percent. Accordingly, while the FASB provided a more principles­based approach to determining the classification of a lease, it is likely that lessees will elect to continue to use the 75 percent and 90 percent thresholds to determine lease classification. Even though right­of­use assets and lease liabilities associated with operating leases will be recognized on the balance sheet, the income statement differences between the subsequent accounting for finance leases and operating leases will continue to give lessees an incentive to structure leases to obtain operating lease classification. The bright­line criteria that may be elected in applying ASC 842 will continue to facilitate the structuring of arrangements to achieve operating lease classification. Lessors (particularly those who use leasing as a means of selling products) may have different motivations than lessees, which could lead them to elect a more principles­based approach to classifying leases. Under ASC 840, a lessor may need to purchase residual value insurance in order to satisfy the 90 percent test to classify the lease as a sales­type lease. In most cases, there is not a meaningful transfer of risk to the insurer, but there is still a cost to the lessor. Because third­party residual insurance is not considered in determining whether the lease qualifies as a sales­type lease under ASC 842, adopting a principles­based approach to classification may allow a lessor to continue classifying leases as sales­type leases after the adoption of ASC 842. A lessor that establishes such an accounting policy would have to apply the same policy to any arrangements in which it is the lessee, which could result in classifying those leases as finance leases. While the fifth condition is new (at least, as a stand­alone factor), it should not change the classification of leases as compared to the classification under ASC 840. Under ASC 840, lessees and lessors would consider the specialized nature of the leased asset in determining if the lease term and minimum lease payments should include periods covered by renewal options or should include the exercise of a purchase option. If the nature of the asset is so specialized that it has no alternative use to the lessor at the end of the lease term, the lessor has every incentive to structure the lease in such a way that it will recover its investment and a return on that investment. Therefore, the lessor would either structure the lease as non­cancellable or would build in a penalty substantial enough to economically compel the lessee to exercise a lease renewal option or purchase option, in which case the lessee and lessor would include the payments for periods covered by lease renewal options or purchase options that are reasonably certain of being exercised in determining lease classification. One change the FASB has made to the classification criteria could have a significant effect on the classification of leases involving certain types of assets. Unlike ASC 840, ASC 842 does not require a lease involving real estate or integral equipment to transfer title to the lessee by the end of the lease term for the lease to qualify as a sales­type lease. Eliminating that requirement could result in more leases involving real estate or integral equipment qualifying as sales­type leases under ASC 842. If the lease includes a purchase option that appears to be a bargain, lessors will need to consider whether consequences to the lessee that are incurred only if the lessee exercises the purchase option affect the conclusion that exercise of the option is reasonably certain. For example, if, by exercising the purchase option, the lessee would assume the lessor's obligation to remove the leased asset at the end of the asset's useful life, the lessor would need to consider whether the costs associated with that obligation are so significant that exercise of a purchase option that is nominally a bargain is not reasonably certain. Because ASC 840 did not permit classification of a lease involving real estate or integral equipment to qualify as a sales­ type lease on the basis of an evaluation of whether a purchase option was reasonably certain to be exercised, the elimination of the requirement that title transfer by the end of the lease term will increase the judgments a lessor will need to make in determining lease classification. Lease Payments Possibly the most significant change affecting lease classification relates to the lease payments used in determining the classification of the lease. ASC 842 requires the lessor (and permits the lessee) to allocate the consideration in the contract between lease and non­lease components, and notes that components of an agreement are those items or activities, such as maintenance, that provide a good or service to the lessee. If an item or activity does not provide a good or service to the lessee, any consideration attributable to that item or activity remains as part of the lease payment. Under ASC 840, lessees and lessors are required to reduce lease payments for any payments relating to executory costs (payments to reimburse the lessor for taxes, insurance and maintenance). ASC 842 does not provide for that further allocation and makes it clear that payments to reimburse the lessor for administrative tasks to set up a contract or initiate a lease or to reimburse or pay the lessor's costs, such as for taxes and insurance on the leased asset, do not transfer a good or service to the lessee. Accordingly, the portion of the consideration in the contract allocable to reimbursing the lessor's costs for taxes and insurance would be considered a lease payment. Depending on the significance of those costs, the classification of the lease could change from the classification under ASC 840. The consideration in the contract that a lessor is required (and a lessee is permitted) to allocate between lease and non­lease components includes the lease payments identified in paragraph 5 of ASC 842­10­30, plus any other fixed payments or variable payments that depend on a rate or index required under the terms of the arrangement that are not already included in lease payments. Under ASC 842, lease payments used in determining classification include the following: • Fixed and in substance fixed payments, less any lease incentives paid or payable to the lessee.

• Variable lease payments that depend on an index or a rate measured using the index or rate at the commencement date.

• The exercise price of a purchase option that the lessee is reasonably certain to exercise. • Payments for penalties for terminating the lease if the lease term (determined consistently with current practice under ASC 840) reflects the exercise of the option to terminate the lease.

• Fees paid by the lessee to the owners of a special­purpose entity for structuring the transaction.

• For a lessee, any guarantee by the lessee of the residual value at the expiration of the lease term. For a lessor, any guarantee of the residual value at the expiration of the lease by the lessee or a third party unrelated to the lessor.

In addition to the above, a lessor would include any variable consideration that relates to the transfer of goods or services that are not leases based on the variable consideration guidance in ASC 606 Revenue from Contracts with Customers. If the variable consideration relates even partially to the lease component, the lessor would not include any amount of variable consideration in determining the consideration in the contract. If the lessee is obligated to reimburse the lessor's actual costs for taxes and insurance, the payment will likely qualify as a variable lease payment and would thus be excluded from classifying the lease. Lease payments for leases that are structured to require lessees to reimburse the lessor's actual costs will be lower than lease payments for leases that are structured to require the lessee to pay the lessor a fixed amount (or a fixed amount that increases if the actual costs are greater, as is the case in most gross leases) to cover those costs. A lessee allocates the consideration in the contract to the separate lease and non­lease components on the basis of relative standalone prices of the separate components. While ASC 842 uses different wording (“relative standalone prices”) from ASC 840 (“relative fair values”) to describe the basis for allocating consideration, any differences between the allocation under ASC 842 and the allocation under ASC 840 should not be significant. However, unlike ASC 840, ASC 842 allows a lessee to make an accounting policy election not to allocate the consideration between lease and non­lease components, in which case the consideration would be allocated entirely to the lease components. A lessee may make that election by type of underlying asset. Depending on the significance of the non­lease components, an accounting policy election to treat the consideration in the contract as allocable entirely to the lease component increases the likelihood of classifying the lease as a finance lease. A lessor is required to allocate the consideration in the contract using the guidance in ASC 606. Lessors do not have the option to make an accounting policy election to allocate the consideration entirely to the lease component similar to the election available to lessees. If the consideration in the contract includes any variable consideration, the lessor would allocate the variable consideration entirely to the non­lease component. Collectibility and Unreimbursed Costs ASC 840 requires lessors to consider two additional factors for leases that meet one of the criteria in paragraph 1 of ASC 840­10­25 to be classified as a sales­type or direct financing lease. Paragraph 42 of ASC 840­10­25 requires the lease to meet both of the following conditions: • The collectibility of the minimum lease payments is reasonably predictable.

• There are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor under the lease, such as a guarantee of the performance of the leased property in a manner more extensive than the typical product warranty.

In determining whether to recognize a sales­type lease at the commencement date under ASC 842, a lessor considers the collectibility of the lease payments. If the lessor cannot conclude that collectibility of lease payments and any residual value guaranteed by the lessee is probable at the commencement date, the lessor does not derecognize the leased asset until it is able to conclude that collectibility is probable (in other words, the collectibility assessment does not affect the classification of a lease that meets the criteria in ASC 842 to be a sales­type lease; it only affects when the lessor recognizes the sales­type lease). The lessor will defer the recognition of any payments received from the lessee prior to the lessor concluding that collectibility of all payments is probable. In contrast, under ASC 840, if the lessor is unable to conclude that collectibility of minimum lease payments is probable, it would account for the arrangement as an operating lease and would at least recognize the payments received as lease revenue. Under ASC 842, collectibility only affects lease classification if the lease does not qualify as a sales­type lease. As noted previously, the lessor considers collectibility in determining whether a lease qualifies as a direct financing lease, and classifies the lease as an operating lease if it is unable to conclude that collectibility is probable, which is the same result that would be obtained under ASC 840. If the lessor retains risks associated with the leased asset, such as by providing a warranty that is more extensive than a normal warranty, the lessor will evaluate whether that involvement represents a non­lease component and, if it is, allocates a portion of the total consideration in the contract to that component, as provided in ASC 606. Under ASC 840, such continuing involvement would require the lessor to account for the arrangement as an operating lease. Rate Implicit in the Lease The FASB made one minor change to the definition of the interest rate implicit in the lease in ASC 840 to align the definition with the definition in IAS 17. However, that change will have a significant impact on the ability of a lessee to determine the implicit rate in certain lease transactions. Under ASC 842, the rate implicit in the lease is defined as: The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor.

The change from ASC 840 relates to the inclusion of the lessor's initial direct costs in calculating the implicit rate. Because the lessee will not know the amount of initial direct costs, if any, that the lessor will defer (at least, in the absence of the lessor telling the lessee), it will be missing a component of the calculation. Accordingly, the lessee will not be able to readily determine the implicit rate. In contrast, under ASC 840, a lessee can determine the implicit rate in synthetic and terminal rental adjustment clause (TRAC) leases where there is a low probability that the fair value of the asset at the end of the lease term could be less than the residual value guaranteed because the implicit rate does not consider the lessor's initial direct costs. Because the implicit rate is usually lower than the lessee's incremental borrowing rate, the change in how the implicit rate is computed will facilitate structuring leases where the lessor satisfies the 90 percent test using the implicit rate, but the lessee is able to classify the lease as an operating lease based on its use of the incremental borrowing rate. Incremental Borrowing Rate ASC 842 defines “incremental borrowing rate” as: The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.

The definition of “incremental borrowing rate” in ASC 842 represents a change from how that term was defined under ASC 840. The definition under ASC 842 makes it clear that the lessee is required to assess the rate as a secured rate. Under ASC 840, a lessee was to determine a rate that was “consistent with the financing that would have been used in the particular circumstances,” which could have resulted in the lessee using an unsecured borrowing rate. Accordingly, if a lessee used an unsecured rate to determine lease classification under ASC 840, the adoption of ASC 842 should result in it utilizing a lower discount rate for determining whether the lease qualifies as an operating lease. When combined with other changes from ASC 840, there is a greater chance that leases classified as operating leases under ASC 840 will be finance leases under ASC 842. Because of the difficulty of determining the incremental borrowing rate, ASC 842 also provides a practical expedient to private companies by allowing those reporting entities to use a risk­free rate to determine lease classification. While the risk­free rate is certainly easier to determine than the incremental borrowing rate, the use of the risk­free rate could result in more leases qualifying as finance leases becausethe present value of the lease payments determined using the risk­free rate will be greater than the present value determined using the incremental borrowing rate. Accordingly, private company lessees will need to carefully consider the implications if they elect to use the risk­free rate. Differences from IAS 17 As noted previously, the FASB incorporated the classification criteria from IAS 17 into ASC 842. However, the Board did not incorporate all of the classification criteria from IAS 17. In addition to the criteria the FASB did incorporate, paragraph 11 of IAS 17 provided guidance that supplemented the primary classification criteria. Paragraph 11 of IAS 17 states: Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are:

(a) if the lessee can cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee;

(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and

(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.

The additional indicators, in particular the second, would result in the classification of synthetic or TRAC leases as finance leases under international financial reporting standards, even though such leases would likely be classified as operating leases under ASC 840. Because the FASB did not incorporate the additional criteria from IAS 17 into ASC 842, a lessee that elects to classify leases using the 75 percent and 90 percent thresholds will continue to classify those leases as operating leases. However, if a lessee were to adopt a principles­based approach to lease classification, such leases would be classified as finance leases because the leases transfer substantially all of the future economic benefits associated with the assets to the lessee. Conclusion ASC 842 retains substantially the lease classification criteria from ASC 840, which should slightly ease the burden of transitioning to the new guidance. While ASC 842 may not result in increasing the number of leases classified as finance (capital) leases by lessees, reporting entities will need to consider whether processes and internal controls over classifying leases require modifications because of the changes the FASB did make. Although ASC 842 may not increase the number of finance leases reported by lessees, the new standard satisfies the original objective of the project to replace ASC 840 because it will require lessees to recognize an asset and a liability for substantially all leases.

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